how money works

MHOONWEY

WORKS

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HOW$

MONEY

$ WORKS

THE FACTS
VISUALLY EXPLAINED

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Senior editor Kathryn Hennessy Publisher Liz Wheeler
Project editor Publishing director Jonathan Metcalf
Senior art editor Sam Kennedy Karen Self
Project art editor Art director Mark Cavanagh
Gadi Farfour Senior jacket designer Clare Gell
UK Editors Sophia MTT
Saffron Stocker Jacket editor
US Editors Jacket design Gillian Reid
Designers Alison Sturgeon, Allie Collins, Diane Pengelley, development manager Mandy Inness
Georgina Palffy, Jemima Dunne, Tash Khan Pre-production producer
Managing editor Senior producer
Senior managing art editor Christy Lusiak, Margaret Parrish

Clare Joyce, Vanessa Hamilton,
Renata Latipova

Gareth Jones

Lee Griffiths

Contents PROFIT-MAKING AND FINANCIAL
INSTITUTIONS 24
Introduction
8 Corporate accounting 26
MONEY BASICS
Net income 28
The evolution of money
Barter, IOUs, and money 10 Expensing vs capitalizing 30
Artifacts of money Depreciation, amortization, depletion 32
Emergence of modern
Smoothing earnings 34
economics
Economic theories and money Cash flow 36

12 Gearing ratio and risk 40

14 How companies use debt 42

16 Financial reporting 44

20 Financial instruments 46

22 Shares 48

Bonds 50

Derivatives 52

Financial markets 54
The money market 56
Foreign exchange and trading 58
Primary and secondary markets 60
Predicting market changes 62
Arbitrage 64
Manipulating the stock market 66
Day trading 68

Financial institutions 70
Commercial and mortgage banks 72
Investment banks 74
Brokerages 76
Insurance risk and regulation 78
Investment companies 80
Nonbank financial institutions 82

First American Edition, 2017 All rights reserved. A WORLD OF IDEAS:
Published in the United States by DK Publishing Without limiting the rights under the copyright reserved SEE ALL THERE IS TO KNOW
345 Hudson Street, New York, New York 10014 above, no part of this publication may be reproduced, stored
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Copyright © 2017 Dorling Kindersley Limited
DK, a Division of Penguin Random House LLC any form, or by any means (electronic, mechanical,
photocopying, recording, or otherwise), without the prior
17 18 19 20 21 10 9 8 7 6 5 4 3 2 1
001–282964–March/2017 written permission of the copyright owner.
Published in Great Britain by Dorling Kindersley Limited.

A catalog record for this book is available from the Library
of Congress.

ISBN: 978-1-4654-4427-1

Printed in China

GOVERNMENT FINANCE 84
AND PUBLIC MONEY

The money supply 86 $
Increasing money circulation 88
Banking reserves 90 $
Recession and the money supply 92
Recession to depression 94 $

Managing state finance 96
Government and the money supply 98
The central bank 100
Budget constraint 104
How tax works 106
Government borrowing 108
Public debt 110
Accountability 112

Attempting control 114
Reading economic indicators 116
Deciding on economic policy 118
Interest rates 120
Quantitative easing 124
The level of taxation 126
Government spending 128
How governments provide for
130
the future 132
Inflation 136
Balance of payments 138
International currency fluctuations 140
Managing state pensions

Why governments fail 142
financially 144
How governments fail: hyperinflation
146
How governments fail: debt default

Contributors Marianne Curphey is an award-winning financial writer,
blogger, and columnist. She has worked as a writer and editor
Beverly Harzog (consultant and writer) is a consumer at The Guardian, The Times, and The Telegraph, and a wide
credit expert and best-selling author. Her articles have range of financial websites and magazines.
appeared in The Wall Street Journal, New York Daily News,
ABCNews.com, ClarkHoward.com, CNNMoney.com, and Emma Lunn is an award–winning personal finance journalist
MSNMoney.com. Her expert advice has been featured in whose work regularly appears in high profile newspapers such
numerous media outlets, including television, radio, print, as The Guardian, The Independent, and The Telegraph, as well
and websites.  as a number of specialty publications and websites.

PERSONAL FINANCE 148 Wealth-building investments 174
Investing in property 176
Worth, wealth, and income 150 Home equity 180
Calculating and analyzing net worth 152 Shares 182
Income and wealth 154 Managed funds 184
Converting income into wealth 156
Generating income 158 Managing investments 186
Generating wealth 160 Asset allocation and diversification 188
Dollar cost averaging 190
Investments for income 162 Risk tolerance 192
Dividends from shares 164 The optimal portfolio 194
Earning income from savings 166
Investing in managed funds 168 Pensions and retirement 196
Rental income from property 170 Saving and investing for a pension 198
Life assurance 172 Converting pensions into income 202

Debt 204
Why we use debt 206
Interest and compound interest 208
Loans 210
Mortgages 212
Credit unions 216
Credit cards 218

Money in the digital age 220
Cryptocurrency 222
Bitcoin 224
Crowdfunding 226
Peer-to-peer lending 228

Money in the US 230
Index 248
Acknowledgments 256

James Meadway is an economist and policy advisor who has Alexandra Black studied business communications before
worked at the New Economics Foundation—an independent writing for financial newspaper group Nikkei Inc. in Japan and
British think tank—the UK Treasury, the Royal Society, and for working as an editor at investment bank JP Morgan. She has
the Shadow Chancellor of the Exchequer. written numerous books and articles on subjects as diverse as
finance, business, technology, and fashion.
Philip Parker is a historian and former British diplomat
and publisher, who studied at the Johns Hopkins School of
Advanced International Studies. A critically acclaimed author,
he has written books that focus on the history of world trade.

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SOLD

HOW MONEY WORKS 89
Introduction

Introduction

$¥£ $€ Money is the oil that keeps the machinery of our world turning. By
€£ giving goods and services an easily measured value, money facilitates
$ the billions of transactions that take place every day. Without it, the
¥ industry and trade that form the basis of modern economies would
grind to a halt and the flow of wealth around the world would cease.
$$
Money has fulfilled this vital role for thousands of years. Before its
invention, people bartered, swapping goods they produced themselves
for things they needed from others. Barter is sufficient for simple
transactions, but not when the things traded are of differing values, or
not available at the same time. Money, by contrast, has a recognized
uniform value and is widely accepted. At heart a simple concept, over
many thousands of years it has become very complex indeed.

At the start of the modern age, individuals and governments began
to establish banks, and other financial institutions were formed.
Eventually, ordinary people could deposit their money in a bank
account and earn interest, borrow money and buy property, invest
their wages in businesses, or start companies themselves. Banks
could also insure against the sorts of calamities that might devastate
families or traders, encouraging risk in the pursuit of profit.

Today it is a nation’s government and central bank that control a
country’s economy. The Federal Reserve (known as “The Fed”) is
the central bank in the US. The Fed issues currency, determines
how much of it is in circulation, and decides how much interest it
will charge banks to borrow its money. While governments still print
and guarantee money, in today’s world it no longer needs to exist as
physical coins or notes, but can be found solely in digital form.

This book examines every aspect of how money works, including
its history, financial markets and institutions, government finance,
profit-making, personal finance, wealth, shares, pensions, Social
Security benefits, and national and local taxes. Through visual
explanations and practical examples that make even the most
complex concept immediately accessible, How Money Works
offers a clear understanding of what money is all about, and
how it shapes modern society.

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MONEY
BASICS

❯ The evolution of money

The evolution
of money

People originally traded surplus commodities with each other in a process known
as bartering. The value of each good traded could be debated, however, and
money evolved as a practical solution to the complexities of bartering hundreds
of different things. Over the centuries, money has appered in many forms, but,
whatever shape it takes, whether as a coin, a note, or stored on a digital server,
money always provides a fixed value against which any item can be compared.

The ascent of money

Money has become increasingly complex over
time. What began as a means of recording trade
exchanges, then appeared in the
form of coins and notes, is
now primarily digital.

Barter Evidence of trade records Coinage
(10,000–3000BCE) (7000BCE) (600BCE–1100CE)

In early forms of trading, specific Pictures of items were used to record Defined weights of precious metals
items were exchanged for others trade exchanges, becoming more used by some merchants were later
agreed by the negotiating parties complex as values were established formalized as coins that were usually
to be of similar value. See pp.14–15 and documented. See pp.16–17 issued by states. See pp.16–17

MONEY BASICS 12 13
The evolution of money

SUPPLY AND DEMAND $80.9
trillion
The economic law of supply and demand
states that when the price of a commodity estimated amount of money
(such as oil) falls, consumers tend to use, or in existence today
demand, more of it, and when its price rises,
the demand decreases. One of the key
factors affecting price is the amount of a
commodity available—its supply. Low supply
will push prices up, as consumers are willing
to pay more for something that is difficult to
obtain, and high supply will push prices
down as consumers will not pay a premium
for something that is plentiful.

Bank notes Digital money Macro versus
(1100–2000) (2000 onward) Microeconomics

States began to use bank notes, Money can now exist “virtually,” on Macroeconomics studies the impact
issuing paper IOUs that were traded computers, and large transactions can of changes in the economy as a
as currency, and could be exchanged take place without any physical cash whole. Microeconomics examines
for coins at any time. See pp.18–19 changing hands. See pp.222–223 the behavior of smaller groups.

Macroeconomics

This measures changes in
indicators that affect the
whole economy.

❯❯Money supply The amount of
money circulating in an economy.

❯❯Unemployment The number of
people who cannot find work.

❯❯Inflation The amount by which
prices rise each year.

Microeconomics
$ This examines the effects

that decisions of firms and
individuals have on the economy.

❯❯Industrial organization The
impact of monopolies and cartels
on the economy.

❯❯Wages The impact that salary
levels, which are affected by
labor and production costs,
have on consumer spending.

Barter, IOUs, and money

Barter—the direct exchange of goods—formed the basis of trade for
thousands of years. Adam Smith, 18th-century author of The Wealth
of Nations, was one of the first to identify it as a precursor to money.

Barter in practice Direct Trade

Essentially, barter involves the exchange Simple exchange
of an item (such as a cow) for one or One party directly
more of a perceived equal “value” (for swaps its item (a cow)
example a load of wheat). For the most for the other party’s
part the two parties bring the goods
with them and hand them over at the goods (wheat)
time of a transaction. Sometimes, one
of the parties will accept an “I owe you,”
or IOU, or even a token, that it is agreed
can be exchanged for the same goods
or something else at a later date.

PROS AND CONS T rading with IOUs
OF BARTER
IOU
Pros
Summer Wheat is COW
❯❯Trading relationships Fosters delivered in exchange
strong links between partners. for an IOU for a cow.

❯❯Physical goods are exchanged IOU
Barter does not rely on trust that
money will retain its value. COW

Cons Winter Once the cow is
fully grown it is handed
❯❯Market needed Both parties over to fulfill the IOU.
must want what the other offers.

❯❯Hard to establish a set value
on items Two goats may have a
certain value to one party one
day, but less a week later.

❯❯Goods may not be easily divisible
For example, a living animal cannot
be divided.

❯❯Large-scale transactions can be
difficult Transporting one goat is
easy, moving 1,000 is not.

MONEY BASICS 14 15
The evolution of money

How it works an IOU to be exchanged later for the physical goods.
Eventually these IOUs acquire their own value and the
In its simplest form, two parties to a barter transaction IOU holder could exchange them for something else of
agree on a price (such as a cow for wheat) and physically the same value as the original commodity (perhaps
hand over the goods at the agreed time. However, this apples instead of wheat). The IOUs are now performing
may not always be possible—for example, the wheat the same function as actual money.
might not be ready to harvest, so one party may accept

Complex trading with IOUs $

IOU Money A universal
IOU that has an agreed

value in terms of
the goods it can be

exchanged for.

CLOTHES IOU

IOU Trading in IOUs WHEAT
IOUs can be exchanged
FENCE BUILDING between different parties, IOU
or for a variety of items
IOU (not necessarily the one FIREWOOD

first agreed on).

COW

IOU

APPLES

Artifacts Characteristics of money
of money
Money is not money unless it has all of the
Since the early attempts at setting following defining characteristics: Money must
values for bartered goods, “money” have value, be durable, portable, uniform,
has come in many forms, from IOUs divisible, in limited supply, and be usable as
to tokens. Cows, shells, and precious a means of exchange. Underlying all of these
metals have all been used. characteristics is trust—people must be
confident that if they accept money,
they can use it to pay for goods.

How it works Item of worth

Bartering was a very immediate form of Most money originally had
transaction. Once writing was invented, records an intrinsic value, such as that
could be kept detailing the “value” of goods of the precious metal that was
traded as well as of the “IOUs.” Eventually
tokens such as beads, colored cowrie shells, used to make the coin. This
or lumps of gold were assigned a specific value, in itself acted as some
which meant that they could be exchanged
directly for goods. It was a small step from this guarantee the coin would
to making tokens explicitly to represent value be accepted.
in the form of metal discs—the first coins—in
Lydia, Asia Minor, from around 650BCE. For
more than 2,000 years, coins made from
precious metals such as gold, silver, and (for
small transactions) copper formed the main
medium of monetary exchange.

Timeline of artifacts

5,000bce Sumerian 1,000bce Lydian gold coins 600bce
cuneiform tablets In Lydia, a mixture of
Barter Cowrie shells gold and silver was Athenian drachma
Early trade involved Scribes recorded Used as currency The Athenians used
directly exchanged transactions on clay across India and the formed into disks, silver from Laurion
tablets, which could South Pacific, they or coins, stamped to mint a currency
items—often also act as receipts. appeared in many with inscriptions.
perishable ones colors and sizes. used right across
such as a cow. 4,000bce 600bce the Greek world.

MONEY BASICS 16 17
The evolution of money

Store of value GEORG SIMMEL AND
THE PHILOSOPHY OF MONEY
Money acts as a means by
which people can store their Published in 1900, German sociologist Georg Simmel’s book The
wealth for future use. It must not, Philosophy of Money looked at the meaning of value in relation to
therefore, be perishable, and it money. Simmel observed that in premodern societies, people made
helps if it is of a practical size objects, but the value they attached to each of them was difficult to
fix as it was assessed by incompatible systems (based on honor, time,
that can be stored and and labor). Money made it easier to assign consistent values to objects,
transported easily. which Simmel believed made interactions between people more
rational, as it freed them from personal ties, and provided greater
freedom of choice.

€ Means of $$
$ exchange
Unit of
It must be possible to account
exchange money freely and
widely for goods, and its value Money can be used to record
should be as stable as possible. wealth possessed, traded, or
It helps if that value is easily spent—personally and nationally.
It helps if only one recognized
divisible and if there are authority issues money—if
sufficient denominations so anybody could issue it, then

change can be given. trust in its value would
disappear.

Han dynasty coin 27bce Byzantine coin 900ce Arabic dirham
Often made of Early Byzantine Many silver coins
Roman coin coins were pure Anglo-Saxon coin from the Islamic
bronze or copper, Bearing the head of gold; later ones also This 10th century empire were carried
early Chinese coins the emperor, these contained metals silver penny has an
had holes punched such as copper. inscription stating to Scandinavia
coins circulated that Offa is King by Vikings.
in their center. throughout the 700ce (“rex”) of Mercia.
Roman Empire. 900ce
200bce

ARTIFACTS OF MONEY

The economics of money By the early 20th century, money became separated
from its direct relationship to precious metal. The Gold
From the 16th century, understanding of the nature of Standard collapsed altogether in the 1930s. By the
money became more sophisticated. Economics as a mid-20th century, new ways of trading with money
discipline emerged, in part to help explain the inflation appeared such as credit cards, digital transactions,
caused in Europe by the large-scale importation of and even forms of money such as cryptocurrencies and
silver from the newly discovered Americas. National financial derivatives. As a result, the amount of money
banks were established in the late 17th century, with in existence and in circulation increased enormously.
the duty of regulating the countries’ money supplies.

GOLD AND SILVER FROM 1540-1640 COPPER 1542–1551
THE NEW WORLD
Potosi inflation The great
debasement
The Spanish discovered
silver in Potosi, Bolivia, and England’s Henry VIII
caused a century of inflation debased the silver penny,
making it three-quarters
by shipping 350 tons of
the metal back to copper. Inflation
Europe annually. increased as trust

dropped.

1970 FROM 1844

Great inflation Gold Standard

In the US, inflation The British pound was tied
accelerated quickly. to a defined equivalent
amount of gold. Other
The stock market countries adopted a
plummeted 40% in an similar Gold Standard.

18-month period.

1970S £ $ 1990S
¥
Credit cards Digital money

The creation of credit The easy transfer of
cards enabled consumers funds and convenience
to access short-term credit of electronic payments
to make smaller purchases.
became increasingly
This resulted in the popular as internet
growth of personal
use increased.
debt.

MONEY BASICS 18 19
The evolution of money

GRESHAM’S LAW 16 billion

The monetary principle “bad money drives out good” was the number of bitcoins
formulated by British financier Sir Thomas Gresham (1519-71). in circulation in 2016—
He observed that if a country debases its currency—reducing worth $9 billion
the precious metal in its coins—the coins would be worth
less than the metal they contained. As a result, people spend
the “bad” coins and hoard the “good” undebased ones.

JOINT-STOCK 1553 1694
COMPANY
Early joint-stock Bank of England
companies
$ The Bank of England
Merchants in England was created as a body that
began to form companies in could raise funds at a low
interest rate and manage
which investors bought national debt.
shares (stock) and
shared its rewards.

1775 1696

US dollar The
Royal Mint
The Continental
Congress authorized the Isaac Newton became
issue of United States dollars Warden and argued that
in 1775, but the first national debasing undermined
currency was not minted confidence. All coins were
recalled and new silver
by the US Treasury
until 1794. ones were minted.

1999 2008

Euro Bitcoin

Twelve EU countries Bitcoin—a form of
joined together and electronic money that
replaced their national exists solely as encrypted
currencies with the Euro.
Bank notes and coins data on servers—is
were issued three announced. The first
transaction took place
years later.
in January 2009.

Emergence of modern
economics

By the 18th century, people began to study the economy more closely, as thinkers
tried to understand how the trade and investment decisions of individuals could
have an effect on prices and wages throughout a country.

How it works (laissez-faire) might improve their people’s economic
well-being. In the 18th century, economist Adam Smith
With the massive expansion of trade that accompanied proposed that government intervention—controlling
the discovery of the Americas and the growth of wages and prices—was unnecessary because the
nation states in Europe in the 16th and 17th centuries, self-interested decisions of individuals, who all want
individuals began to think in more detail about the to be better off, cumulatively ensure the prosperity
idea of economics. They variously suggested that of their society as a whole. In addition, he believed that
controlling the level of imports (mercantilism), trading in a freely competitive market, the impetus to make
only in the goods a country made best (comparative profit ensures that goods are valued at a fair price.
advantage), or choosing not to intervene in the markets

Adam Smith’s SELLER A $4 SELLER B NEW!
“invisible hand” $2

In his book The Wealth of Nations Seller A is charging too much Seller B sees an opportunity to
(1776), the Scottish economist Adam for his goods but still makes sales enter the market and sets up her
Smith suggested that the sum of the because he is the only seller and own stall, selling at a lower price
decisions made by individuals, each enjoys an effective monopoly. in order to undercut A.
of whom wanting to be better off,
results in a country becoming more BUYER
prosperous without those individuals
ever having consciously desired that Buyers reduce their As Seller B’s price is lower,
end. According to Adam Smith, where purchases as prices are buyers begin to buy from her
there is demand for goods, sellers will prohibitively high. instead of Seller A.
enter the market. In the pursuit of
profit they will increase the production
of these goods, supporting industry.

Furthermore in a competitive
market, a seller’s self-interest limits the
price rises they can demand in that if
they charge too much, buyers will
stop purchasing their goods or lose
sales to competitors willing to charge
less. This can have a deflationary
effect on prices and ensures that the
economy remains in balance. Smith
referred to this market mechanism,
which turns individual self-interest
into wider economic prosperity, as an
“invisible hand” guiding the economy.

MONEY BASICS 20 21
The evolution of money

PROTECTIONISM AND MERCANTILISM

Adam Smith’s encouragement decrease its imports, as exports “By pursuing his
of free trade and competition brought money into a country, own interests, he
was at odds with the dominant while imports enriched foreign frequently promotes
economic theories of his time. merchants. This theory led to that of the society
Most thinkers supported some strict governmental trade more effectually
form of protectionism—an controls—the Navigation Acts than when he really
economic policy in which a forbade trade between Britain intends to promote it”
government imposes high trade and its colonies in anything
tariffs in order to protect its other than British ships. Adam Smith, The Wealth of Nations (1776)
industry from competition. In
Europe at the time this took the Mercantilism began to go out
form of mercantilism, which of fashion in the late 18th
held that to be strong, a country century under the pressure of
must increase its exports and new ideas about economic
do everything possible to specialization put forward by
Adam Smith and David Ricardo.

SELLER A $3 SELLER B $3 NEED TO KNOW

Seller A drops his price slightly Seller B sees she can raise her ❯❯Market equilbrium When
in order to regain customers price slightly and her goods will the amount of certain goods
and compete with Seller B. still be in demand. demanded by buyers matches the
amount supplied by sellers—the
The goods have found a price point at which all parties are
at which buyers are happy satisfied with a good’s price.
to continue to purchase. The
“invisible hand” has worked and ❯❯Laissez-faire An economic
the market is now in equilibrium. theory that holds that the market
will produce the best solutions in
the absence of government
interference. Trade, prices, and
wages do not need to be
regulated, as the market itself will
correct imbalances in them.

❯❯Comparative advantage
The idea that countries should
specialize in those goods they
can produce at the lowest cost.
By avoiding producing goods
in which they do not have a
comparative advantage, countries
will become more efficient and
therefore better off.

Economic theories
and money

Since the birth of modern economic thought, economists have tried
to work out how the quantity of money in an economy affects prices
and the behavior of consumers and businesses.

DEFENSE

Keynes’ general CTURE LICING
theory of money TRANSPORTATION INFRASTRU
WELFARE, HEALTHCARE, EDUCATION, AND PO
In his 1935 book General Theory, John Maynard Keynes $
argued that government spending and taxation levels
affect prices more than the quantity of money in the
economy. He proposed that in times of recession a
government should increase spending to encourage
employment, and reduce taxes to stimulate the economy.

$ BUILDING: HOUSES, SCHOOLS, HOSPITALS
STIMULATING DEMAND
GOVERNMENT INVESTMENT AND SPENDING
When output is shrinking and As demand falls, firms reduce The government increases its spending,
unemployment rising, a government production, which raises for example on infrastructure. This
reduces unemployment.
must decide how to react. unemployment and lowers demand.

Fisher’s quantity theory of money Marx’s labor theory of value

The most common version of this theory was articulated The German economist Karl Marx argued that the real
by Irving Fisher, who argued that there is a direct link price (or economic value) of goods should be determined
between the amount of money in the economy and price not by the demand for those goods, but by the value of
level, with more money in circulation increasing prices. the labor that went into producing it.

$10

Low money Demand for High demand Money buys 1 pair 2 hours’ labor $
supply money rises increases value more goods of shoes at $10 / hour
$20
$15
$
High money Demand for Low demand Money buys 1 dress 10 hours’ labor
at $10 / hour $100

supply money reduces decreases value fewer goods

MONEY BASICS 22 23
The evolution of money

How it works an equilibrium price by itself. By the early 20th century,
some economists believed that intervention by the
Scholars in the early 16th century were the first to note government was necessary to maintain a balanced
that the abundance of silver coming into Spain from economy, arguing that government spending could
the New World led to increased prices. Economists boost employment by increasing overall demand.
of the 18th-century Classical School believed that the
market would correct for such imbalances, reaching

COMPANY WAGES

SALES FIGURES COMPANY MULTIPLIERS MORE MONEY IN THE ECONOMY
MULTIPLIERS
COMPANY

GOODS

$

NVESTMENT
I

PRODUCTION INCREASE BUSINESSES SPEND MORE ECONOMY IN BALANCE
With more people in employment, With demand rising, firms invest With levels of investment and production high, and
consumer spending rises. Increased more, opening more factories and
demand leads to increased production. employment and wages rising, the stimulation of
providing more employment. extra government spending is no longer needed.

Hayek’s business cycle Friedman’s monetarism

Austrian economist Friedrich Hayek noted a cycle in the Milton Friedman argued that governments could raise
economy, in which interest rates fall during a recession. or lower interest rates to affect the money supply. Cuts
This leads to an overexpansion of credit, necessitating would stimulate consumer spending; rises would restrict
a rise in interest rates to counter excess demand. it and reduce the amount of money in the supply.

Interest rates LOW INTEREST $100 $100 $100
raised to 1%
REAL GDPInterest rates $ $
ECOVERYcut to 0.25%
CORR
Employee Spends Supermarket Supplier pays
paid $100 $100 pays supplier $100 employees $100
$50

ECTION
R HIGH INTEREST $50 $50

$ $

RECESSION EXPANSION RECESSION Employee Saves $50 and Supermarket Supplier pays
TIME paid $100 spends $50 pays supplier $50 employees $50

$ $$
$$

$ $$
$$

%

€

$

$

PROFIT-
MAKING
AND
FINANCIAL
INSTITUTIONS

❯ Corporate accounting ❯ Financial instruments
❯ Financial markets ❯ Financial institutions

£

¥$

$

Corporate
accounting

Companies use money in different ways—some borrow to pay for investment
to grow bigger, while others prefer to hold a lot of cash and to rely on income
generation rather than borrowing in order to expand. Much depends on the
type of business and the management style. Start-ups and smaller companies
tend to need a lot of cash in the early days, while larger, more established
companies are better at growing their income internally and may hoard cash.

Cashflow Smoothing earnings Net income

This indicates how much This business practice, aimed at This is the income that a
income a business is reducing volatility in income and company reports at the end of
generating, and how this reported profit, uses accounting the financial year after costs
compares to its costs and techniques to limit fluctuations and expenses have been
the expenses that it has to in company earnings. deducted. It is calculated by
pay out. A company is said See pp.34–35 starting with the revenue
to have a positive cashflow earned and then taking away
if its income exceeds its the cost of tax, expenses,
expenses. See pp.36–39 banking and interest charges,
depreciation of assets, staff
$$ $ costs, and any other expenses
$ $ involved in operating the
business. See pp.28–29

Income = $10,000

$$
$
$ $ $ $$ $ $$
$ $ $$ $$
$
$ $ $$ $ $$
$$ $$
$

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 26 27
Corporate accounting

$216 billion

cash reserves held by Apple in April 2016,
out of $1.7 trillion held by US nonfinancial
companies at that time

Gearing ratio Expenses Assets

Capital gearing is the balance These are the costs a These are the items that a
between a company’s capital business incurs on a company owns, some of
(its available money or assets) regular basis. They which generate income,
and its funding by short- or might include staff and many of which may
long-term loans, expressed wages, insurance appreciate in value.
as a percentage. A company premiums, utility bills, Businesses often choose
with relatively low gearing is and other expenses between buying assets
regarded as being less risky involved in the running that will fall in value or
and in a better position to cope of the company. leasing equipment.
with an economic downturn.
See pp.40–41 Expensing vs Capitalizing
Debt = $2,000
When a business incurs a cost or an expense it needs
THE to record it in the company accounts, either by showing
ACCOUNTANT the full amount at the time it happens, or by spreading
the cost over a number of years. See pp.30–31

Depreciation

This is a measure of how much the value
of an asset falls over time, often due to
use or “wear and tear.” Companies can
record the reduction in the value of
assets such as vehicles, machinery, or
other equipment as depreciation in
their accounts. This will then reduce
the company’s tax liability and reduce
their taxable profit. See pp.32–33

Net income

When a business reports how it has fared financially over the year, it
provides investors with a figure for its net income. This is a good way
to understand how much real profit a business is making.

How it works Net income is a good way to understand how much
real profit a business is making, and whether that
If businesses were simply to report the money they profit is likely to be sustained in the future. It is also
had earned, this would give an unrealistic picture of a way of calculating earnings per share (see “Need
the underlying health of the business. For example, to know”), which investors use to weigh up the value
a business could be earning plenty of revenue, but of a company and its shares.
also incurring a lot of expenses via investment in
new markets, premises, or machinery at the same time. Analyzing the balance of revenue earned against
the cost of tax, investment, and other expenses is one
In order for investors to work out whether a company of a number of ways to assess how a company is faring
is financially healthy, therefore, they need to be able to compared with its competitors, and if it has a sound
see how it is managing costs, and whether it is financial basis going forward.
spending money in the right way.

Calculating net PROPERTY DEVELOPER
income
TO$T1A0L0R,0E0V0ENUE
For investors trying to decide whether
a particular company represents a $20,000 Materials
good investment opportunity, net
income helps them to understand the Expenses $40,000 Staff
way the business is run and is a guide
to the real profit the company is
making, rather than just the revenues
it is generating. Revenue earned is
the starting point, and the cost of
tax, banking and interest charges,
depreciation of assets, staff costs,
and any other expenses involved in
operating the business are deducted
from this figure.

Bottom $5,000 Tax
line $35,000 Net income

REVENUE — EXPENSES =
NET INCOME

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 28 29
Corporate accounting

INFLATING EARNINGS $18.4
billion
Some companies omit certain expenses Apple’s first quarter
from their calculations to make net income COSTS net income in 2016 −
appear higher, while others inflate earnings the highest quarterly
to make profits appear higher, for example COSTS profits in history
by including projected future earnings. This
is at best unethical, and potentially illegal.
In 2014, British grocery chain Tesco
launched an investigation after discovering
its first-half earnings estimate had been
inflated by around $407 million due to
alleged accounting errors. So, while net
income is an important indicator of a
company’s financial health, it should not be
used as the only means of assessment.

RETAILER NEED TO KNOW

TOTA$L1R0E0V,0E0N0UE ❯❯Bottom line Refers to the
bottom of the income statement,
$10,000 Rent and is another expression for
net income.
$30,000 Staff
❯❯Earnings per share Net income
$22,000 Stock purchased Expenses divided by the number of shares
$20,000 Tax Bottom in issue; it is seen as an indicator
$18,000 Net Income line of a company’s profitability.

❯❯Expenses The costs incurred
in running a business that have
to be settled immediately, rather
than paid off gradually over a
number of years.

❯❯Depreciation of assets The
decline in value of assets that
the company has bought; this
may be a plant for manufacturing
processes, or specialty machinery.

❯❯Banking and interest charges
The cost of finance, including
loans, debts, mortgages, and
other amounts owing.

Expensing vs
capitalizing

When a business incurs a cost it needs to record it in its
company accounts. The company can do this for the full amount
at the time it happens, or spread the cost over several years.

Capitalizing Assets
and expensing
in practice SKI LIFT SNOWPLOW FURNITURE PASSENGER
The significant The snowplow is Furniture appears BUS
All companies have costs and cost of building
expenses. Some such as electricity and the lift is spread paid off over on the balance The passenger bus
other utilities, insurance, staff wages, over a number several years, as sheet as a cost is recorded as a
and food need to be paid for upfront, deductions from
so these are expensed. To qualify as of years. annual income. spread over depreciating asset
capital expenditure, an asset must three years. as its value will fall.
be useful for more than one year.
Businesses have to decide which Capitalizing
option best fits their business model.
A ski resort buys a new ski lift, A business may decide to capitalize a cost, and then
snowplow, and bus, as well as some spread it over a number of years. Capitalizing means
furniture, and capitalizes the cost. recording an expense as an asset, and then allowing for
its depreciation, or fall in value, over time. Accounting this
WARNING way may be the difference between reporting a profit
or a loss if the cost or expense is particularly large.
Whether a cost incurred can
legitimately be recorded as an THE BALANCE SHEET When to expense
asset is open to a degree of
interpretation. Some recent When to capitalize If a firm expenses some of its costs,
financial scandals have involved its profitability may be lower. This
companies recording one-off For businesses wanting to have a may be useful in order to reduce
business expenses as investments smoother flow of reported income tax; lower profits mean lower
in new markets that they projected and for start-up businesses, it taxation. A company may also
would pay off in the future. The can be attractive to capitalize choose to expense a cost if it
companies did this to inflate or purchases because by keeping has had a good year and wants
“flatter” their profits rather than costs down, a business can to show high profitability in
show the true figures. An order or report a higher income in its later years. Some costs, such as
an expense that had not yet been early years. However, there are staff payments, must be expensed.
paid for was recorded as income tax implications if it is making a
earned, and as a result company larger profit as a result.
earnings appeared higher than
they actually were.

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 30 31
Corporate accounting

How it works provide value for more than one year, it can be
recorded as an asset once depreciation is accounted for.
Business owners and managers have a choice. They Known as capitalizing, this practice has the advantage
can record an expense as it occurs or at the time of of taking costs out of the business gradually, rather
payment and reduce the annual profit accordingly. than in one lump sum. The profit-and-loss account is
This practice, known as expensing, will show up not as dramatically affected in this case.
immediately in the account. If the expense will

Expenses

“Stressing accounting
appearance over
economic substance

achieves neither”

Warren Buffett

Expensing INGREDIENTS
Ingredients for the
With ongoing expenses, a business chalet meals must
will either record the cost at the time
it is incurred, or at the time when it is appear on the
actually paid. This is likely to lead to balance sheet in full.
more volatility in reported earnings,
but may be useful if the company ELECTRICITY/
is trying to keep its profits down, for UTILITIES
example for tax purposes.
Bills must be paid
at once and can’t
be capitalized.

STAFF
Staff are an ongoing
cost, but they must
be paid immediately

and are therefore
an expense.

INSURANCE
Insurance appears as

an expense that is
accounted for in full
in the financial year.

Depreciation,
amortization, depletion

The cost of a company’s assets and its use of natural resources can be
deducted from its income for accounting and tax purposes. Depreciation,
amortization, and depletion allow the company to spread this cost.

Calculating depreciation VALUE ($) $21,000
$25,000 1
A delivery company buys a van for $25,000. Over time, the $20,000
vehicle will need to be replaced. The company can record $15,000
the reduction in the value of the vehicle in its accounts as depreciation. $10,000

PURCHASE − SCRAP ANNUAL $5,000
VALUE VALUE DEPRECIATION ($)
= 0
USEFUL ECONOMIC
LIFE (YEARS)

$25,000 − $5,000 = $4,000
5

Calculating amortization VALUE ($) $21,000 $18,000
$25,000
A company buys the patent for a computer design. The initial $20,000
cost of this intangible asset can be gradually written off over $15,000
several years and can be used to reduce the company’s taxable profit. $10,000

INITIAL COST = ANNUAL $5,000
USEFUL LIFE AMORTIZATION ($)
0
$21,000 = $3,000 12
7

Calculating depletion NUMBER M$IL1L0ION M$I9L.L1ION M$I8L.L2ION
OF TREES
A forestry company knows that it has a finite number of trees.
Depletion records the fall in value of the forest with its 60,000
remaining reserves, as the product—wood pulp—is extracted over time. 50,000
40,000
COST − SALVAGE VALUE X UNITS EXTRACTED = DEPLETION 30,000
TOTAL UNITS EXPENSE ($) 20,000

$10,000,000 − $1,000,000 X 6,000 = $900,000 01 2 3
60,000

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 32 33
Corporate accounting

How it works a physical presence, such as a patent) can be gradually
written off over a number of years. Depletion is the
Depreciation is used to calculate the declining value reduction in value of an asset that is a natural
of tangible assets (such as a machine or vehicle). It resource. Unlike amortization, which deals with
is a measure of how much the value of an asset falls nonphysical assets, depletion records the fall in
over time, particularly due to use, or wear and tear. value of actual reserves. It could be applied to coal or
Amortization is a term used in accounting to describe diamond mines, oil and gas, or forests, for example.
how the initial cost of an intangible asset (one without

$17,000 $13,000 $9,000 WARNING
2
$5,000 ❯❯Country differences There
$15,000 are different ways of allowing for
3 4 5 TIME (YEARS) depreciation, and accounting
methods vary from one country
$12,000 $9,000 to another. When working out
how much a company is allowing
$6,000 $3,000 for the cost of depreciation, it is
important to know which method
is being used in its accounts.

❯❯Purchasing vs leasing assets
Business owners have to make
a choice between buying assets
that they own but that will fall
in value over time, or leasing
equipment on which they will pay
rent. As they do not own leased
equipment, they cannot record its
depreciation in value over time
and there is no depreciation
charge to be used to reduce the
company’s taxable profit.

3 4 5 6 60%7 TIME(YEARS)
the value the
M$I7L.L3ION M$I5L.L5ION M$I4L.L6ION M$I3L.L7ION average car
M$I6L.L4ION 6 7 8 loses after
M$I2L.L8ION M$I1L.L9ION MI$L1LION 3 years on
45 9
the road10
TIME (YEARS)

Smoothing earnings

This is a business practice aimed at reducing volatility in company
income and reported profit. Smoothing involves the use of accounting
techniques to limit fluctuations in a company’s earnings.

How it works been low, they can instead make NEED TO KNOW
provision for those costs in a
Investors like to see companies subsequent year, when the ❯❯Making provision The setting
demonstrate a steady increase in company’s income has increased. aside of money for future
income and profits over time, rather expenses or potential liabilities.
than large fluctuations between Smoothing earnings is generally
income in good and bad years. a legal and legitimate practice and ❯❯Balance sheet A company’s
is a way of spreading profits over income, expenditure, assets,
It is possible for companies to a number of years. By using this capital reserves, and liabilities.
smooth their earnings to avoid accounting practice, the financial
these sorts of large fluctuations. For statements of a company will show ❯❯Profit and loss account A
example, managers can manipulate regular and steady growth, which financial statement showing a
figures by choosing when to make encourages people to invest in it. company’s net profit or loss in a
provision (set aside money) for large However, it can also be used given period of 6 or 12 months.
expenses. Rather than making illegally, to disguise or hide losses
large investments, paying back and encourage investors to buy ❯❯Volatility The ups and downs
loans, or making provision for big into a company that is insolvent. of income or reported profits.
costs in a year in which income has

Volatile earnings

Company A does not keep money in reserve to pay
for large expenses or to cover its running costs in
case of a downturn in profits. It is therefore more
vulnerable to fluctuations in its income.

SPEND Slump: company
has no reserves
Good times:
company spends The company suffers an
unexpected downturn in
Profits are higher than profits, but has no money set
anticipated, so the aside. It may struggle to meet
company spends money its running costs and will be
on new equipment, staff less attractive to investors.
bonuses, and advertising.
It does not keep any EMPTY
money in reserve.

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 34 35
Corporate accounting

FAMOUS ACCOUNTING SCANDALS

Even large, well-known companies can be guilty of manipulating their
profit-and-loss accounts. The biggest scandals of recent years included
that of Enron, at the time one of the top seven US companies.

ENRON (2001) WORLDCOM (2006) BERNIE MADOFF LEHMAN BROTHERS
Shareholders in this This communications (2008) (2008)
large US company lost company appeared
a combined $74 billion. to have far more assets Investors were paid This investment bank,
When the company than it actually owned, returns out of their founded in 1850,
collapsed, accountants thanks to false entries own money, and the had $50 billion of
found that the balance business was only losses in the form
sheet had huge hidden detailing sales that of worthless assets
debts that had not never existed. It sustained by
may have inflated new investors being on its balance sheet.
been declared. recruited. Investors in It went bankrupt, a
its assets by as much major factor in the
as $11 billion. the scheme lost global financial crisis.
around $65 billion.

Smoother earnings WARNING

Company B smooths its earnings by setting Reading a company’s financial
money aside during profitable years to use statement does not always give the
at a later date, for example to repay a loan full picture. Some of the world’s
or cover any unexpected large expenses. biggest corporate finance scandals
have involved hidden losses, loans
Figures are managed made to look like income, and
misstated profits to make the
Income is higher than usual, company in question appear
so the extra revenue is solvent when it is not.
stockpiled and then pushed
on to the following year. “We’re not
Profits therefore appear to managing
be steadily increasing. profits, we’re
managing
businesses.”

Jack Welch

Cash flow

The money coming into and going out of a business is called cash flow.
Inflows arise from financing, operations, and investment, while outflows
include expenses, costs of raw materials, and capital costs.

Capital Sales revenue
Investment and lump sums Cash for goods and services sold

❯❯Main source of cash inflow for start-ups ❯❯Revenue generated by core operations
❯❯Profit that does not have to be repaid, unlike loans
❯❯Additional cash injection after the initial start-up
or capital
❯❯Revenue from flotation (going public) ❯❯Payment received for goods and services provided
of private companies, and from shares issued by ❯❯Also known as cash flow from operating activities
public companies

❯❯Also known as cash flow from investing activities

CASH IN
CASH IN

Cash in hand

CASH OUT CASH OUT CASH OUT

Salaries and wages Overheads Loan repayments
Payments to employees Payment of bills Debt servicing and
shareholder profit
❯❯Money paid to employees who ❯❯Rental cost of commercial
are directly involved in the property; utility bills (water, ❯❯Interest on long-term loans for
creation of goods or the provision electricity, gas, telephone, and asset purchases and on short-
of services internet); office supplies and term loans for working capital
stationery
❯❯Salaries paid to staff as a fixed ❯❯Repayments on loans
monthly or weekly amount ❯❯Salaries and wages of employees ❯❯Commission paid to factoring
(based on an annual rate) not directly involved in creating
goods and services (known as (payment-collecting) companies
❯❯Wages paid to contractors for indirect labor) ❯❯Share repurchases and dividend
hours, days, or weeks worked
payments to shareholders

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 36 37
Corporate accounting

How it works investment, and other sources. It flows out to pay rent,
utilities, employees, suppliers, and interest on loans.
Cash flow is the movement of cash into and out of a Timing income to correspond with outgoings is key.

business over a set period of time. Cash flows in from

the sale of goods and services, from loans, capital

Loans Other revenue
Bank loans and overdrafts Grants, donations, and windfalls

❯❯Working-capital loans to meet shortfalls, using ❯❯Grants from government or other institutions
anticipated income as collateral – usually for research and development

❯❯Advances on sales invoices from factoring ❯❯Donations and gifts (not-for-profit
(payment-collecting) companies organizations)

❯❯Short-term overdrafts ❯❯Sales of assets and investments

❯❯Also known as cash flow from financing activities ❯❯Repayment received for loans made
to other organizations

❯❯Tax refunds

CASH IN
CASH IN

or stock

CASH OUT CASH OUT CASH OUT

Suppliers Tax Equipment
Payments for materials Payments to tax authorities Purchase of fixed assets
and services
❯❯Corporation tax based on profits ❯❯Cost of building and equipment,
❯❯Cost of raw materials needed to shown in annual financial such as computers and phones,
manufacture goods for sale statements office furniture, vehicles, plant,
and machinery
❯❯Cost of stock—local or imported ❯❯Payroll tax paid by employers on
❯❯Fees for services (consulting or behalf of employees ❯❯Offset by depreciation.
See pp.32–33.
advertising) to generate revenue ❯❯Sales tax and/or VAT on goods
❯❯Payments to contractors involved or services

in providing goods and services ❯❯The type and rate of taxes vary
depending on national tax laws

CASH FLOW

Cash flow management In order to manage cash flow, it is WARNING
essential for companies to forecast
The survival of a business depends cash inflows and outflows. Sales Top five cash flow problems
on how it handles its cash flow. predictions and cash conversion
A company’s ability to convert its rates are important. A schedule ❯❯The slow payment of invoices.
earnings into cash—its liquidity— of when payments are due from
is equally important. No matter customers, and of when a business ❯❯A gap between credit terms—for
how profitable a business is, it has to pay its own wages, bills, example, outgoings set at 30 days
may become insolvent if it cannot suppliers, debts, and other costs, and invoices set at 60–120 days.
pay its bills on time. A new can help to predict shortfalls.
business may even become a If cash flow is mismanaged, a ❯❯A decline in sales due to the
victim of its own success and business may have to hand out economic climate, competition, or
fail through “insolvency by money before it receives payment, the product becoming outmoded.
overtrading” if, for example, it leading to cash shortages. Smart
spends too much on expansion businesses, such as supermarkets, ❯❯Underpriced products, usually
before payments come in, and receive stock on credit, but are paid in start-ups that are competing.
then runs out of cash to pay in cash—generating a cash surplus.
debts and liabilities. ❯❯Excessive outlay on payroll and
overheads, for example when
buying rather than hiring assets.

Positive and negative cash flow CASH IN

CASH IN

CASH IN HAND CASH IN HAND
INCREASES STABLE
CASH
OUT CASH OUT

Positive cash flow Stable cash flow

Cash flowing into the business is Cash flows into the business at the same rate at which it flows out. A business
greater than cash flowing out. The doing well may decide that it can afford to increase its investments or pay higher
stock, or reserve of cash, increases. dividends. Despite these extra expenses, the fact that its cash stock remains
A business in this position is thriving. stable is a sign that a business is healthy.

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 38 39
Corporate accounting

NEED TO KNOW ❯❯Cash conversion Successful 80%
businesses convert their product
❯❯Factor A third party which, for a or service into cash inflows before of small business
commission, collects payment from their bills are due. start-ups fail due
a business’s customers. to poor cash flow
❯❯Operating cash flow Inflows and management
❯❯Accounts payable Payments a outflows relating to a company’s
business has to make to others. day-to-day activity.

❯❯Accounts receivable Payments ❯❯Investing cash flow Movement of
a business is due to receive. money into and out of a company
from investments in bonds,
❯❯Aging schedule A table charting businesses, or stock markets.
accounts payable and accounts
receivable according to their dates. ❯❯Financing cash flow Payments due
to or from debitors and creditors.
❯❯Cash flow gap The interval
between when payments are
made and when they are received.

CASH IN NO HANDLING THE FLOW
CASH IN
A business with a cash
CASH IN HAND CASH DRIES UP surplus might:
DECREASES
❯❯Invest or move excess cash into an
CASH NO account where it will earn interest.
OUT CASH
OUT ❯❯Upgrade equipment to improve
production efficiency.
Negative cash flow Bankruptcy
❯❯Take on new staff, develop
Less cash is flowing into the business If cash flowing out continues to exceed products, or buy other companies
than is flowing out. Over time, the cash flowing in, cash levels will drop to expand the business.
stock of cash will decrease and the so low that the business will become
business will face difficulties. insolvent, having no cash to pay its bills. ❯❯Pay creditors early or pay down
debt before it is due to improve
credit credentials.

A business with a cash
shortage might:

❯❯Lower prices to increase sales, or
raise them to increase profit.

❯❯Invoice promptly and chase
outstanding payments.

❯❯Ask suppliers to extend credit.

❯❯Offer discounts in return for
quicker payment.

❯❯Use an overdraft or short-term
loan to pay off pressing expenses.

❯❯Continue to forecast cash flow
and plan to avert future problems.

Gearing ratio COMPANY HAS MORE DEBT
and risk A high proportion of debt to equity
is also described as a high degree of
financial leverage. Typical examples
of debt are loans and bonds.

Capital gearing is the balance between the capital a EQUITY
company owns and the funding it gets from short- or long-
term loans. Investors and lenders use it to assess risk.

How it works Equity finance (shares) Low gearing

Most businesses operate on Pros EQUITY
some form of gearing (also called
financial leverage), funding their ❯❯Low gearing is seen as a measure
operations in part by borrowing of financial strength
money via loans and bonds. If the
level of gearing is high (that is, the ❯❯Low risk attracts more investors
business has taken on large debt and boosts credit rating
in relation to its equity), investors
will be concerned about the ability ❯❯Finance from shares does not have
of the business to repay the debt. to be repaid
However, if the company’s profit is
sufficient to cover interest payments, ❯❯Shareholders absorb losses
high gearing can provide better
shareholder returns. The optimum ❯❯Angel investors share expertise
gearing level depends on how risky
a company’s business sector is, the ❯❯Good for start-ups, which may
gearing levels of its competitors, take a while to become profitable
and the company’s maturity.
Gearing ratios vary from country Cons
to country. Firms in Germany and
France often have higher ratios ❯❯Shared ownership, so company
than those in the US and UK. founders and directors have
limited control of decisions

❯❯Profit is shared in return for
investors risking their funds

❯❯There is a legal obligation to act
in the interests of shareholders

❯❯Complex to set up

Gearing ratio calculation Low gearing

Analysts and potential investors assess A software company is going public. Its ratio of 21.2 percent tells
the financial risk of a company with this investors that it has relatively low gearing and is well positioned
calculation, presented as a percentage. to weather economic downturns.

LONG-TERM DEBT × 100 $1.2 MILLION × 100 = 21.2%
SHARE CAPITAL + $2 MILLION + $2.455 MILLION +

RESERVES + $1.2 MILLION
LONG-TERM DEBT

High PROFIT-MAKING AND FINANCIAL INSTITUTIONS 40 41
Corporate accounting

gearing Debt finance (loans) NEED TO KNOW
DEBT
Pros ❯❯Interest cover ratio An
DEBT alternative method of calculating
COMPANY HAS LESS DEBT ❯❯Debt payments do not change gearing: operating profit divided
A low proportion of debt to equity is with profitability by interest payable.
also described as a low degree of financial
leverage. Equity typically comes from ❯❯Interest payments are tax ❯❯Overleveraged A situation in
reserves and share capitals. deductible which a business has too much
debt to meet interest payments
❯❯Debt does not dilute ownership on its borrowing.

❯❯Company retains control of ❯❯Deleverage The immediate
decision-making payment of any existing debt in
order to reduce gearing.
❯❯Repayment is a known amount
that can be planned for ❯❯Creditors Those to whom a debt
is due or a payment needs to be
❯❯Quicker and simpler to set up made (shareholders are always
behind loan-holders in the order
❯❯Small business loans at favorable of repayment).
rates may be available to start-ups
❯❯Dilution Angel investors—people
Cons who provide finance and invest
in the future of a start-up
❯❯High gearing is considered a company—will usually receive
measure of financial vulnerability, shares in return. This is known as
as debt payments must be made diluting ownership, as the angel
even if profits are low investors will own part of the
company and may hold sufficient
❯❯High risk may put off investors shares to have a controlling stake.
and adversely affect credit rating
25%
❯❯Loans and interest must be paid,
even if operating profit shrinks the ratio at
or below which
❯❯Debt may be secured on fixed a company is
assets of a company. Unpaid traditionally
lenders can seize assets and said to have
force bankruptcy low gearing

❯❯Tax authorities and lenders
are to be paid first in the event
of insolvency

High gearing

A water company is the only water provider in the area, with several
million customers. Although high, the ratio of 64 percent is acceptable
for a utility company with a regional monopoly and a good reputation.

$360 MILLION × 100 = 64%
$82 MILLION + $120 MILLION +

$360 MILLION

How companies
use debt

When a company wants to expand, it has two main funding options—
to borrow money or to issue shares to investors. Borrowing money at a
fixed price enables it to budget for costs and calculate potential profits.

How it works money via issuing shares may borrow, a company would be
have to allow larger shareholders a unable to take on large projects
By taking on debt—in other words, say in how the business is run. If and make long-term commitments.
borrowing money—a firm receives the company then makes a profit,
a lump sum of cash, paying back it may have to pay dividends to If a lender is concerned about
the full amount with interest in shareholders. Unlike loans, shares how a company is being run, or
regular payments over a fixed do not get “paid off”; dividends its future ability to pay its debt, it
term to its creditors. It also retains are paid as long as shares exist. may have the option to withdraw
control over its business strategy, the loan or ask the company
unlike when shares are sold. Firms may use both methods to reschedule its debt, thereby
to fund investment, and each paying a higher rate of interest
By issuing shares, a company is approach has different pros and to compensate the lender for the
selling ownership (equity) stakes cons, but without the facility to increased potential risk.
in the business. A firm that raises

Business expansion AIR $?

Some companies, for example those AIR Planes wants to expand its AIR
in air travel, car manufacturing, or operations because it foresees
house building, tend to have higher greater demand from customers It plans to construct a new
levels of debt because they have manufacturing plant and needs
to purchase stock, raw materials, in the future.
or land well before they sell their to raise money to buy the
products or services. site and build the factory.

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 42 43
Corporate accounting

NEED TO KNOW GETTING THE BALANCE RIGHT

❯❯Creditors Banks, loan A company that borrows money as opposed to issuing shares has fixed liabilities
companies, and individuals to and a time table for repayment. It retains more independence as the creditors
whom a firm owes money. don’t have a share of the profits or a say in how the company is run. There are
also tax advantages—it is cheaper for a firm to bear the cost of debt than equity.
❯❯Dividends Profits paid to a
company’s shareholders. Too
risky!
❯❯Interest payment The amount
of interest charged on a loan. This $ DEBT
is usually fixed and has to be paid
on time in installments—even if ASSETS $
the company is struggling and
losing money. LENDER $$ $
$
❯❯Lifecycle The “debt phase” a
company is in. Start-ups tend to $
be funded by small bank loans
and seed capital, turning to DEBT ASSETS
venture capital when they expand,
which may involve issuing shares. Too much debt, and it won’t attract any Too little debt, and it may be forced
lenders, as it is seen as too risky. But using to give away too much control and
debt, it is able to retain more of its profits. profits to new shareholders.

AIR BANK 1 Length LOAN
3% A

SHARES BANK 2 Length LOAN In five years AIR is in profit.
VS 5% B A PROFIT

BANK LOAN $
$$ B

BANK C AIR

BANK 3 Length LOAN AIR does not need to pay any of its
7% C profit to its creditors. The company
only has to repay each loan at the
In order to retain control of The firm opts for a debt package
its own decisions, AIR opts for from three different banks. Each end of its respective term.
a bank loan rather than selling charge different rates and terms.

shares in its ownership. A contract is drawn up.

Financial reporting

Financial reporting is when a company Case study: balance sheet
publishes statements showing its assets
(what it owns), its liabilities (what it $
owes), and its financial status. This
information is used by investors to This example, from a water company, shows
keep track of the company’s progress. how a balance sheet works.

How it works ASSETS, LIABILITIES, AND CAPITAL

There are legal requirements around financial Fixed assets
reporting to ensure that a company gives a full and Intangible assets
fair statement of its financial affairs. The company Tangible assets
must show its performance over the year or half Investments
year, any significant changes to its financial position,
and whether it has made money or incurred liabilities Current assets
or losses during the year. Stock and work in progress
Debtors
Two financial reports are usually issued per year— Cash at the bank and in hand
the half-year report, and the annual report. For firms Total current assets
that are publicly owned—i.e. their shares are traded on Creditors—amounts coming due within one year
the stock market—the annual report must be made Net current assets
public and freely available for investors to read.
Total assets less current liabilities
Companies usually publish a number of documents:
an annual report showing the firm’s activities during Creditors—amounts coming due after more
the year; a balance sheet showing its current assets than one year
and liabilities, and the working capital (difference Provisions for liabilities and charges
between the two); a statement of cash flows and Retirement benefit obligations
statement of stockholder’s equity; and financial details Deferred income
on its website for investors. This information is used by
investors to keep track of the company’s progress. Net assets
Stockholders’ equity
WARNING Issued share cap
Retained profit (or earnings)
A balance sheet is a snapshot of a company’s financial
position on one particular day. Although it is a good Shareholders’ funds
guide to the financial health of a company, doctored
reports can, and in the past have been used to, hide large SYMBOLS FOR DEBITS AND CREDITS
debts or liabilities, and not reveal them to the auditors Accountants use a number of different terms and symbols to
who are checking the annual report or balance sheet. indicate debits and credits. Some use “Dr” for debits and “Cr” for
Auditors may be alerted to fraud by a number of “red credits, others use “+” for debits and “–” for credits. On this balance
flags” or warning signs—these could be anything from sheet, brackets are used to show credits (negative numbers).
negative cash flows that miraculously become positive
the following year, to sales registered before they have
been made, to an unusual rise in gross margin.

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 44 45
Corporate accounting

Year 2013 Year 2012 Fixed assets (or non-current assets) cannot easily
$m $m be converted into cash and are usually bought for
long-term use. They are either tangible, such as
0 0 land, or intangible, such as brand logos.
2,167.1 2,069.2 Intangible assets are assets that are not physical—
for example intellectual property (IP) or trademarks.
– – They have a value but are distinct from tangible
assets such as stock, property, and premises.
7.0 6.3 Current assets include all assets that could be
162.6 153.9 converted into cash—cash reserves within the
181.0 211.0 business and petty cash; stock; insurance claims;
350.6 371.2 office equipment; accounts receivable.
(198.8) (171.7) Debtors are individuals or companies that owe the
151.8 199.5 firm money. Debtors will usually have an agreement
with their creditors about terms of payment.
2,318.9 2,268.7 Creditors are the individuals or organizations to
(1,891.5) (1,811.9) which the company owes money. Here, the money
must be repaid in the current financial year.
(114.9) (115.3) Net current assets are current assets after money
(93.1) (83.0) due to creditors has been deducted.
(17.2) (17.9) Total assets less current liabilities are all the
202.2 240.6 assets that the company owns that are not likely to
be exchanged for cash, as well as cash, and other
81.3 81.3 liquid assets, minus liabilities.
120.9 159.3 Liabilities due are loans, mortgages, or
202.2 240.6 outstanding debt that the company owes,
and on which it is likely to have to pay interest.
Net assets are the company’s total assets minus the
total liabilities it has. It is the amount of value left
and is sometimes called shareholders’ equity.

Issued share cap is the total number of shares
held by the company’s shareholders.

Retained profit is profit that has not been paid
out as dividends to shareholders and may be
reinvested or used to pay debt in the long term.

Shareholders’ funds, or owner’s equity, is the
company’s remaining net capital; this can be
reinvested or paid out annually as a dividend.

Financial
instruments

A financial instrument is something that has value Shares
and can be traded. This might be cash or currency,
shares, assets, or debts and loans. It can include
evidence of an ownership of interest in a company
or other entity. Many records of financial instruments
are now held electronically.

How they work Companies issue shares to
investors in return for money.
Financial instruments are legal agreements that require one party to pay A legal agreement between
(or promise to pay) money—or something else that has a value—to another a company and a shareholder
person or organization. There are usually conditions attached to an agreement. might include the payment of
These conditions might cover the amount and timing of payments of interest,
cash, capital gains, premiums, or provision of insurance cover as part of the dividends (when and if the
agreement. As proof that you own a financial instrument, you might hold an company can afford to do so),
actual document, such as a share certificate, an insurance policy, or a contract
for a debt or a loan, but shares can also be held in an online account. or perks for as long as the
investor holds the shares.
WHY HOLD FINANCIAL
INSTRUMENTS? See pp.48–49

Growth and dividends $

Investors buy and trade financial instruments in order Currency
to receive a straightforward capital gain, or to receive
interest from a bond or from dividends of shares. Different currencies can be
Risk control held and traded by investors

Buying assets that perform independently of each other to exploit movements in
(shares from one country, and government bonds from exchange rates for profit.
another, for example) can help reduce risk in a portfolio.
Preparing for the unexpected See pp.58–59

An investor wishing to hedge their portfolio might buy
insurance against that portfolio falling in value. Holding
an insurance certificate gives protection against losses
that have been set out and agreed in the policy.

PROFIT-MAKING AND FINANCIAL INSTITUTIONS 46 47
Financial instruments

Derivatives— Bonds and 16%
options and futures loans
rise in the value
of Google shares
in a single day
on Friday, July
17th, 2015

The value of derivatives These are IOUs between NEED TO KNOW
depends on the performance a company and an investor.
of an underlying asset. They The investor effectively loans ❯❯Capital gain Profit from the sale
are traded to provide capital a company or government of assets such as shares.
growth, or to limit risk within money and, in return, the
borrower pays interest to the ❯❯Risk The chance that an
a business or a portfolio. investor over a set period, at investment’s return may be lower
Professional investors may use a set rate, with a specified date or different than expected.
them to hedge their portfolios. for the return of the capital.
❯❯Portfolio A range of investments
See pp.52–53 See pp.50–51 held either by an individual or by
an organization.

Insurance $

An insurance policy involves a Funds
company or individual paying
An investment fund (such
a premium to an insurance as an ETF fund) is a supply of
company, entering into a capital belonging to a group of
contract that promises monetary investors. This money is invested
compensation in the event by the fund in the hope that the
of them suffering a pre-agreed fund’s share price will increase,
loss scenario. See pp.78–79 netting the investors a capital
gain. It may also pay interest.

See pp.80–81

Shares

Shares are units of ownership interest in a corporation that are
available for investors to buy or sell. Companies create shares in order
to raise capital, which they can invest to grow their business.

How it works shares for capital growth (hoping NEED TO KNOW
the underlying value or price of the
Shareholders are investors who buy shares will rise) and for income if ❯❯Listed A share that appears on
the shares a company creates, and the shares pay dividends. Share the register (list) of the stock
who therefore own a part of the prices rise and fall based on a exchange on which it is being
company. When shareholders buy a company’s financial performance, traded (bought or sold).
share, it is usually an “ordinary general economic news, and market
share” or “common share,” which sentiment—how investors feel ❯❯Quote The most recent price at
means that they can vote in the about a company or the wider which a share has been traded.
election of the company’s executive economy. If a share price fluctuates Stock exchanges are now all
team, approve or vote against new in a short space of time it is said to electronic, and prices can be
share issues and other money- be volatile. If one company’s share seen changing minute by minute
raising activities, and in some cases price is volatile it can indicate during the course of the day.
receive payouts known as dividends. investor worries about that
Shareholders are entered on the company; if volatility affects all ❯❯Stocks “Stocks” describes the
company’s shareholder register, share prices it can indicate ownership of shares in general.
which is a list of all the investors instability in entire markets. “Shares” refers to the ownership
who hold a stake in it. Investors buy of shares in a particular company.

Issuing shares COMPANY Share

Companies issue shares when
they need money to invest or pay
off costs. When an investor buys
a share, they become a shareholder
and own a small part of the company.

COMPANY $1s0hpaerer $1.33
COMPANY SHARES

A company needs shares to expand The company issues shares at Individual investors receive their
its operation. It decides to offer shares $10 per share. The shares are shares at the issue price, in this case
to the public via flotation on the made available via an Initial Public $10. The shares can then be bought
stock market. Offering (IPO) at an agreed price. and sold on the stock exchange.