Simple Business

Mark McIlroy
A book about trade and commerce
(c) Blue Sky Technology 2013, All Rights Reserve
!!!"#lueskytechnology"co$"au
CONTENTS
1. Business....................................................................................................... 7
2. Elements of Business.................................................................................21
3. Developing a business..............................................................................228
4. Operating a business................................................................................291
5. Topis....................................................................................................... !""
!. #ummar$ of ma%or onepts & issues.....................................................1"58
'ppen(i) ' * E)ample business plan........................................................1"!7
'ppen(i) B * E)ample #ervie +ontrat....................................................1"7!
'ppen(i) + * #ample legal (ouments......................................................1"82
'ppen(i) D * ,atios an( margins b$ in(ustr$...........................................1"87
'ppen(i) E * -ont.l$ repa$ments of an amortising loan...........................1"89
'ppen(i) / 0 -o(el 'ounts...................................................................1"9"
'ppen(i) 1 0 #ample basi aounts & anal$sis......................................1"91
'ppen(i) 2 0 Option 3riing......................................................................1"92
2
'ppen(i) 4 * #ummar$ of formulas.............................................................1"93
3
Tables & charts
Return on %&uity 's" (earing""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""2)*
Reuction in volatility !ith iversi+ication""""""""""""""""""""""""""""""""""""""""""""""""""302
,oan #alance o+ an a$ortising loan""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""332
Manu+acturing cost, -ro+it . -rouction leverage"""""""""""""""""""""""""""""""""""""""*12
/ost -er unit co$-are to -rouction volu$es""""""""""""""""""""""""""""""""""""""""""""010
2i3e, varia#le an total costs -er unit"""""""""""""""""""""""""""""""""""""""""""""""""""""""""*30
Trens in average an stanar eviation +igures"""""""""""""""""""""""""""""""""""""""")23
Seasonal sales ata""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""")2)
4or$al -ro#a#ility istri#ution"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""")*1
4or$al istri#ution -ro#a#ilities"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""))0
2i3e average . rano$ !alk ata""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""))3
5ro#a#ility o+ an event occurring !ithin a -erio o+ ti$e""""""""""""""""""""""""""""))6
7iversi+ication an -ort+olio volatility""""""""""""""""""""""""""""""""""""""""""""""""""""""""")81
Suggeste risk -re$iu$s""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""8)*
Summaries
Su$$ary o+ $argins . ratios"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""218
Su$$ary o+ istri#ution $ethos""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""000
Su$$ary o+ $anu+acturing issues"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""*13
Su$$ary o+ $anu+acturing calculations""""""""""""""""""""""""""""""""""""""""""""""""""""""*1*
0
Su$$ary o+ risk -ricing a--roaches"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""")66
Su$$ary o+ #usiness insurances""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""811
Su$$ary o+ valuation +igures""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""132
Su$$ary o+ valuation a--roaches"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""1*0
Su$$ary o+ sale $ethos""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""1*1
Su$$ary o+ -ro9ect +inancing alternatives"""""""""""""""""""""""""""""""""""""""""""""""""""631
Su$$ary o+ sensitivity calculation +or$ulas"""""""""""""""""""""""""""""""""""""""""""""""663
Descriptions of terms
Bookkee-ing . Accounting Ter$s""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""*1
2inancial State$ent Ter$s""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""")0
,egal ter$s"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""130
2inancial analysis ter$s"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""216
7e#t ter$s""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""3*0
%&uity ter$s""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""3)0
Statistical ter$s"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""")81
Risk calculation . traing ter$s""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""811
2inance ter$s . a##reviations"""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""""888
*
Terminology
In this te3t, :#usiness o!ner;, :#usiness o-erator;, :shareholer; an
:investor; all re+er to the sa$e situation"
This re+ers to an iniviual that invests $oney in a #usiness enter-rise, an
receives the -ro+its +ro$ the enter-rise"
Technically, the ter$ :shareholer; $ay only a--ly in the case that the
#usiness o-erates using a co$-any as the legal structure"
In the case o+ a -artnershi-, the ter$ :-artner; $ay #e use"
:4et assets; an :e&uity; re+er to the sa$e thing, #eing the +uns that are
hel !ithin the #usiness, !hich are inirectly o!ne #y the investors"
:4et -ro+it; an :net inco$e; an :earnings; all re+er to the increase in
assets !ithin the #usiness ue to the #usiness o-erations"
In the conte3t o+ accounting an +inancial $anage$ent, a :cash; transaction
$ay involve receiving or -aying $oney"
This $ay not involve -hysical currency such as #anknotes an coins"
A -ay$ent #y che&ue or a irect account trans+er $ay #e a cash transaction
in the conte3t o+ +inance"
%3a$-les o+ non<cash transactions $ay inclue the change in the value o+ a
+i3e asset"
:5ro-erty; in the legal an +inancial conte3t $ay re+er to anything o+ value
that is o!ne #y the #usiness, an $ay inclue cash, e&ui-$ent, -atents, lan
an #uilings"
A :-arty; re+ers to an iniviual or situation that $ay #e involve in a
contract, negotiation or transaction"
This $ay inclue an iniviual, a co$-any, a -artnershi-, a trust ee
arrange$ent, an so on"
A :liste; co$-any is a #usiness that is organise as a co$-any structure,
!ith the shares #eing trae on a stock e3change"
Most large #usiness enter-rises are liste co$-anies"
)
1. Business
1.1. Business activity through history
Business is not an invention o+ the $oern age"
Business activity in $oern ti$es is essentially the sa$e as the #usiness
activity that occurre uring the ti$e o+ the Ro$ans, 2,*00 years ago, an
uring the ti$e o+ the %gy-tians, *,000 years ago"
Trae an co$$erce has e3iste in essentially the sa$e +or$ +or as long as
there has #een recore history"
Business activity has not occurre at all ti$es an in all -laces"
7uring $any -erios o+ history, li+e involve #asic -hysical survival, !hile
in other ti$es an -laces, iniviuals live in s$all tri#al grou-s that i not
engage in trae"
=o!ever, !hen occurre, #usiness activity ha the sa$e nature an structure
in the -ast as it oes in the $oern !orl"
The %gy-tians ke-t etaile inventory recors an entere contracts (>>
check contracts)"
Trae !as conucte !ith +oreign lans, an co$$ercial is-utes !ere
settle in a court"
In the ti$e o+ the Ro$ans, various currencies !ere in use, an +oreign
e3change transactions !ere -er+or$e to e3change $oney in one currency
+or $oney in another currency"
Be+ore the ti$e o+ the Ro$ans, !heat !as harveste an +ruit !as -icke in
e3change +or -ay$ent, $oney !as #orro!e, an e#ts !ere re-ai"
7uring the ?? century, trae along the Silk Roa route through Asia carrie
silk an s-ices +ro$ the +ar east to %uro-e, an ?? (>>check) +ro$ %uro-e to
the +ar east"
The 5yra$is o+ the ancient %gy-tians an A@tecs coul not have #een #uilt
!ithout large<scale -ro9ect $anage$ent"
The #est<kno!n -hrase regaring #usiness activity, :/aveat %$-tor;, !as
coine in ,atin"
8
This -hrase translates into %nglish as :#uyer #e!are;"
1.. Commercial activity
/o$$ercial activity inclues -roucing ite$s +or sale, -er+or$ing services
+or +ees, an traing one ite$ +or another"
Trae involves #uying an selling, an e3changing one ite$ +or another"
Trae is a $a9or -art o+ co$$ercial activity, ho!ever it oes not involve any
creation or -rouction o+ its o!n accor"
Trae si$-ly involves e3changing one ite$ +or another ite$"
In $ost cases one o+ the ite$s !ill #e an a$ount o+ cash, ho!ever the net
value that is hel a+ter the transaction is the sa$e as the a$ount hel #e+ore
the transaction, all else #eing e&ual"
5roucing ite$s o+ -ractical value $ay involve +ar$ing, $anu+acturing ite$s
+ro$ ra! $aterials, #uiling, an any other activity !hich results in creating
an ite$ o+ -ractical use"
Services involve any activity that is -ractically use+ul o+ its o!n accor,
rather than activity that results in an ite$ #eing create"
This inclues -ersonal services such as haircuts, organising -ro9ects,
transactions, events, an trans-ort"
/o$$ercial activity oes not involve activity that is not irecte at trae
!ith others"
2or e3a$-le, constructing a #uiling +or -ersonal use, or creating an artistic
!ork, are not co$$ercial activities"
=o!ever, i+ these ite$s !ere later sol to another -arty, then the sale itsel+
!oul #e a co$$ercial transaction"
1.!. Business
Business involves conucting activities o+ a co$$ercial nature"
1
This inclues organising -rouction, trans-orting goos, an conucting
co$$ercial transactions"
/onucting a #usiness activity involves +our +una$ental ste-s"
1" /reating a #usiness +acility"
2" 5roucing ite$s or -er+or$ing services"
3" 5aying e3-enses"
0" Receiving -ay$ent +ro$ clients or custo$ers"
/reating the #usiness +acility $ay not involve any -articular ste-s a-art +ro$
co$$encing the activity" In other cases a range o+ i++erent ste-s $ay #e
involve, such as the +ollo!ing ite$s"
Arranging +uning +ro$ e#t or internal +uns to -ay initial
e3-enses"
Registering !ith govern$ent e-art$ents +or ta3, licenses,
regulation an other -ur-oses"
Arranging insurance that is legally re&uire or -ruent +or the
-articular activity"
Buying or leasing e&ui-$ent"
,easing -re$ises"
5urchasing ra! $aterials"
%$-loying sta++"
In larger enter-rises this $ay involve constructing $anu+acturing +acilities,
an asse$#ling an entire organisational structure"
%3-enses involve any -ay$ents that result in an out+lo! o+ +uns +ro$ the
#usiness" This coul inclue
5ay$ents +or ra! $aterials"
5ay$ents +or services such as legal an accounting services"
5ay$ents to e$-loyees an contractors"
Ta3es"
Interest -ay$ent on e#t"
Rent o+ -re$ises"
,ease -ay$ents +or e&ui-$ent"
Marketing, -ro$otion an avertising costs"
/o$$issions an -ay$ents to agents an istri#utors"
6
2ees an charges are $ae in various !ays" This inclues so$e o+ the
+ollo!ing alternatives"
2i3e ollar cost +or the sale o+ ite$s"
Ti$e<#ase charges, such as an hourly rate +or services"
An<going regular +ees, such as a $onthly charge +or regular
$aintenance"
5ercentage co$$issions an +ees #ase on the si@e o+ the
transaction"
1.". Creation & Battle
Business $ay involve t!o istinct activitiesB creation, an #attle"
1.4.1. +reation
/reation involves -roucing ite$s, esigning -roucts, creating artistic
!orks, an other activity that results in ite$s #eing create +or later sale"
5er+or$ing services creates value, although this $ay not #e in a tangi#le
+or$"
1.4.2. Battle
Battle $ay involve attack, e+ence, an contest"
Attack
Attack occurs on a -ersonal level uring co$$ercial transactions"
2or e3a$-le, -ressure an inti$iation $ay #e a--lie to inuce a -erson to
#uy a -rouct, select a service, or conuct a transaction"
Attack also occurs !ithin co$-etitive $arkets"
10
2or e3a$-le, in co$-arative avertising, a irect co$-arison $ay #e $ae
!ith a co$-etitorCs -rouct as -art o+ the $arketing ca$-aign"
In other cases, the clients or custo$ers o+ a co$-etitor $ay #e irectly
targete, as a !ay o+ increasing sales"
Attack also a--lies to #reaking through #arriers to entry in close $arkets"
In so$e $arkets, a ne! #usiness $ay #e -revente +ro$ o-erating in the
$arket #y long<ter$ links #et!een su--liers an custo$ers, licensing
restrictions or -ro-rietary technology"
At air-orts, +or e3a$-le, a li$ite nu$#er o+ -orts $ay #e availa#le +or
aircra+t, an i+ all -orts !ere tie in long<ter$ leases this $ay -revent other
airlines +ro$ o-erating at that +acility"
Defence
7e+ence a--lies to irect attacks +ro$ co$-etitors, an also to the case o+
changes in the environ$ent in !hich the #usiness o-erates"
Attacks $ay arrive in +or$s such as -rice !ars !ithin an inustry, !here one
su--lier reuces -rices rastically to increase sales an gain a larger share o+
the $arket"
A res-onse this $ay re&uire reucing sale -rices to #elo! the costs o+
-rouction to e+en the e3isting $arket share, resulting in unsustaina#le
-rices"
In the $ore general case, -ro#le$s $ay occur !ith +alling sales, e+aults on
-ay$ents +ro$ custo$ers, a$age to e&ui-$ent, an a range o+ une3-ecte
events that a++ect the survival o+ the #usiness"
7e+ence involves structuring the #usiness, an -re-aring #acku- -lans an
+acilities, so that the a$age cause to the #usiness +ro$ a range o+ -ossi#le
events $ay #e $ini$ise"
Contest
/ontest occurs !ithin #usiness !hen an activity involves a irect co$-etitive
-rocess"
11
5urchasing a -ro-erty at an auction is an e3a$-le o+ contest" In this situation,
co$-eting #is are su#$itte until the -ro-erty is sol"
,oging co$-etitive teners to -urchase an asset or !in a custo$erCs
account +or a service agree$ent is also a contest situation"
1.#. $ro%th & survival
1.5.1. #urvival
Survival is -ri$arily a cash +lo! issue"
Dhile long<ter$ gro!th involves evelo-$ent, assets, an -ro+ita#ility,
survival in the short an $eiu$ ter$ involves cash +lo! an availa#le cash
reserves"

In cases !here the cash in+lo! is less than the cash out+lo!, the o-eration o+
the #usiness !oul #e unsustaina#le on a long<ter$ #asis"
This !oul eventually reuce the assets !ithin the #usiness to @ero, an the
#usiness !oul cease to o-erate"
In other cases the in+lo! $ay #e less than the out+lo! on a te$-orary #asis
ue to seasonal changes, the ti$ing o+ large cash transactions, or +uning o+ a
$a9or evelo-$ent or start<u- activity"
In these cases, survival $ay #e e-enant on a co$#ination o+ increasing
availa#le +uns, reucing out+lo!s, an increasing in+lo!s"
Raising +uns can occur through selling assets, using overra+ts, an loan
+acilities"
In these situations aitional e#t cannot usually #e raise, ho!ever e3isting
e#t +acilities $ay #e availa#le"
Reucing e3-enses $ay involve so$e o+ the +ollo!ing ste-s
/hanging an e3-ense to an alternative !ith a lo!er cost, such as
$oving to alternative -re$ises !ith a lo!er rent"
5ost-oning e3-enses that o not relate irectly to e3isting
-rouction, such as research an -rouct evelo-$ent"
12
/ancelling e3-ense ite$s such as reucing e$-loyee nu$#ers,
cancelling services, an closing -ro9ects or -arts o+ o-erations"
In general there is little irect control over inco$e" In so$e cases inco$e
coul #e increase !ith so$e o+ the +ollo!ing ste-s
/ancelling iscounts, su#siies an other #ene+its -rovie !ith
sales"
Increasing -rices"
Avertising an -ro$otions" =o!ever, in these cases the results o+
the $arketing ca$-aign $ay not +lo! through &uickly enough to
o++set the cost, an cancelling the cost o+ -ro$otions $ay #e o+
greater #ene+it that s-ening +uns !ith the ai$ o+ increasing sales"
1.5.2. 1ro5t.
Dhile survival involves sta#ilising cash +lo!, gro!th involves evelo-$ent
o+ -roucts, using assets a++ectively, an -ro+ita#ility"
A sta#le cash +lo! is necessary to +un gro!th an evelo-$ent, ho!ever
this oes not lea to gro!th o+ its o!n accor"
Profit
5ro+it or loss is the change in the total assets o+ the #usiness ue to #usiness
activities"
This oes not inclue changes in assets ue to ca-ital trans+ers, such as
raising or re-aying e#t"
/a-ital trans+ers $ake the #usiness enter-rise larger or s$aller, #ut o not
re+lect a creation or estruction o+ total value"
4et -ro+it inclues the i++erence #et!een the cash in+lo! an cash out+lo!
over a -erio o+ o-eration"
A change in the value o+ the #usinessCs assets can also occur !hen the value
o+ a +i3e asset changes"
13
7e-reciation is the reuction in the value o+ an asset over ti$e"
2or e3a$-le, e&ui-$ent !orth one hunre ollars at the en o+ the -revious
year $ay only #e !orth ninety ollars at the en o+ the current year"
In this case, the value o+ the #usiness has ecline #y ten ollars, even
through no cash transactions $ay have occurre"
%&ui-$ent is generally recore in the accounts o+ the #usiness !ith a value
that eclines over the use+ul li+e o+ the ite$, !ith the e-reciation e3-ense
#eing inclue as an out+lo! o+ value"
5ro+it is a se-arate issue +ro$ cash +lo!"
4et -ro+it is e&ual to the net cash +lo!, -lus the change in the value o+ other
assets"
7ue to changes in the value o+ +i3e assets, a #usiness $ay have -ositive or
negative cash +lo!, an se-arately have -ositive or negative -ro+it"
2or e3a$-le, i+ the in+lo! to the #usiness is greater than the out+lo!, then
cash +lo! !ill #e -ositive"
=o!ever, i+ the value o+ the e&ui-$ent eclines #y $ore than this a$ount,
then -ro+it !ill #e negative"
/onversely, the cash out+lo! $ay #e greater than the cash in+lo!, leaing to
negative cash +lo!"
=o!ever, i+ the value o+ an asset increase signi+icantly, then the -ro+it $ay
#e -ositive"
Dhile cash +lo! eter$ines the survival o+ the #usiness in the $eiu$ ter$,
the net change in value also inclues non<cash ite$s such as e-reciation"
Growth
(ro!th involves the +ollo!ing ele$ents
/reating a -rouct or service that is attractive to custo$ers or
clients"
7elivering the -rouct at a -rice that is lo! enough to result in the
-rouct #eing -urchase"
10
Avertising, -ro$oting an $arketing to ensure that the -rouct is
availa#le to custo$ers, an that -otential custo$ers are a!are o+ the
-rouct"
5roucing the -rouct on a -ro+ita#le #asis, !ith inco$e +ro$ sales
e3ceeing costs"
Maintaining care+ul control over costs"
Maintaining e+ensive +acilities to avoi serious a$age to the
#usiness ue to -ro#le$s such as cash +lo! shortages, +ire,
e&ui-$ent +ailure, an loss o+ $a9or su--liers or custo$ers"
Re<investing in ne! -roucts, -ro9ects an re-lace$ent +acilities on
a regular #asis"
1.&. 'ies & (eception
,ies an ece-tion $ay #e a signi+icant -art o+ the #usiness environ$ent"
2or e3a$-le, an o++er $ay #e su#$itte to -urchase an ite$"
The seller $ay later res-on #y saying that they have receive a higher o++er
+ro$ another source, an re&uesting that the -rice #e increase"
In so$e cases this $ay #e true, !hile in others it $ay not #e"
7irect +alse state$ents are generally li$ite to s$all transactions"
In larger transactions, si$ilar -ro#le$s $ay arise ue to the i$age an
illusion o+ the situation not re+lecting the actual nature o+ the situation, rather
than a state$ent #eing strictly +alse"
2or e3a$-le, a #usiness -re-aring +or sale $ay cancel the regular
$aintenance o+ e&ui-$ent"
This coul lea to a large reuction in costs, an a resulting increase in
re-orte -ro+it"
In this case, the -ro+it that !as generate #y the #usiness !oul not #e a
sustaina#le +igure, as the e&ui-$ent !oul cease to +unction in a short
ti$e+ra$e i+ the $aintenance !as not restore"
1*
In this e3a$-le, a -urchaser +ailing to $ake the necessary checks $ay -lace
a value on the #usiness that !as a -oor esti$ate o+ the #usinessCs value"
In other cases, a tone o+ voice or attitue $ay create an i$-ression o+ a
situation that is not accurate"
2or e3a$-le, an i$-ression $ay #e create that a negotiation is -roceeing
on a one<to<one #asis, !hen in +act negotiations are also -roceeing !ith
other -arties in the #ackgroun"
In cases such as these, an ine-enent assess$ent o+ the situation is
necessary, rather that relying on an i$-ression -ut +or!ar #y another -arty"
5ro#le$s can also occur !ith state$ents that are $ae in goo +aith, #ut are
incorrect !ithout the kno!lege o+ the -erson $aking the state$ent"
5ro#le$s !ith these situations can #e reuce in a nu$#er o+ !ays"
1" State$ents $ae #y other -arties $ay have li$ite relevance to the
ecision that is involve" They $ay #e eli#erately ece-tive, or $ay #e
$ae in goo +aith #ut $ay #e incorrect ue to other reasons"
In+or$ation su--lie #y other -arties $ay #e +ar $ore a$aging than having
no in+or$ation at all"
Incorrect in+or$ation can lea to $istaken conclusions, +alse i$-ressions,
an taking actions that lea to +uture losses"
7irect investigation is necessary to arrive at a valuation or conclusion,
ignoring outsie in+or$ation !herever -ossi#le"
2" So$e situations -ose a greater risk o+ these -ro#le$s occurring than
others"
2or e3a$-le, -urchasing an ite$ #y auction allo!s the -ossi#ility o+ +alse
#is #eing su#$itte to raise the -rice, !hile this cannot occur !ith an ite$
-urchase at a +i3e -rice"
In so$e cases these situations cannot #e avoie, !hile in other cases,
alternative a--roaches can #e taken to reuce the e3-osure to this ty-e o+
-ro#le$"
1)
3" In a negotiation situation, -ro#le$s $ay #e reuce i+ the issues involve
in the negotiation are thought through #e+ore the negotiation co$$ences, an
ecisions such as $ini$u$ -rices are $ae in avance"
In so$e cases this $ay result in a transaction +ailing to -rocee"
=o!ever, this $ay #e a esira#le outco$e, !hile in other cases it $ay #e a
cost o+ the negotiation -rocess"
0" 'aluation is #ase on in+or$ation"
This inclues in+or$ation a#out the ite$ itsel+, an general in+or$ation a#out
its use+ulness an the value o+ si$ilar ite$s"
(athering a range o+ in+or$ation ine-enently $ay reuce -ro#le$s in
these situations"
*" In so$e cases, ine-enent valuations can #e arrange"
This o-tion is availa#le +or -ro-erties, sales o+ #usinesses, an $ost large
transactions"
Ine-enent valuations o not generally rely on in+or$ation su--lie #y
others, a-art +ro$ in+or$ation su#$itte as a general in-ut to the -rocess"
)" Auiting an other revie!s o+ in+or$ation can #e use to check the
accuracy o+ in+or$ation"
8" Dhere -ossi#le, #uying an selling in o-en $arkets can #e use to reuce
$any o+ the -ro#le$s !ith iniviual negotiation"
A -rice in an iniviual negotiation $ay #e set #y the -erce-tions o+ the
#uyer an seller, the li$ite kno!lege o+ the -arties, an in so$e cases #y
inti$iation, $ani-ulation an strength o+ -ersonality"
In an o-en $arket, -rices are set #y su--ly an e$an"
In turn this is #ase on a large volu$e o+ in+or$ation, an #y a $ultitue o+
iniviual ecisions"
18
So$e ite$s, such as art!orks, are trae at -rices that re+lect the -ersonal
value -lace on the$, rather than their -ractical value"
In general, ho!ever, -rices o+ ite$s such as -ro-erty, invest$ents,
e&ui-$ent an general goos trae at a -rice that re+lects their -ractical
value"

1.). Operation
1.7.1. ,eor( 6eeping
Accurate recor kee-ing is the +ounation o+ a success+ul #usiness activity"
2inancial recors involve a recor o+ cash recei-ts an cash -ay$ents,
-urchases an sales o+ assets, an changes in asset values"
Ather recors inclue stock inventories, custo$er an shi--ing etails, an
-rouct in+or$ation"
2inancial recors can #e reconcile against #ank state$ents to correct
$issing ite$s an errors"
In the case o+ stock lists, these can #e checke #y a $anual stock count"
1.7.2. +as. failities
/ash +lo! -ro#le$s can occur ue to so$e o+ the +ollo!ing eventsE
Ti$ing -ro#le$s, !here large -ay$ents are ue #e+ore inco$e
a$ounts are receive"
7e+aults on -ay$ents #y custo$ers, such as accounts not #eing -ai
#y the ue ate"
Slo! sales"
Seasonal issues, !hen sales occur at certain ti$es o+ the year"
/ash out+lo!s relate to large evelo-$ent -ro9ects
11
/ash +lo! -ro#le$s can #e reuce #y $aintaining an ae&uate cash
#alance, an #y $aintaining stan<#y creit +acilities such as overra+ts"
/reit +acilities are a e+ensive +acility that $ust generally #e arrange in
avance, as aitional creit cannot usually #e raise uring ti$es o+
+inancial istress"
Businesses that o-erate !ith narro! $argins, !ith large cash in+lo!s, large
cash out+lo!s an a s$all $argin o+ i++erence, $ay #e $ore susce-ti#le to
cash +lo! -ro#le$s that other #usinesses"
In these cases, larger cash #alances or creit +acilities $ay #e re&uire"
1.7.3. /inanial -anagement
A-erating a #usiness involves t!o $a9or issues"
A-erational $anage$ent involves organising the activities o+ the #usiness to
result in a s$ooth an e++icient o-eration"
2inancial $anage$ent involves $anaging the cash +lo!, $argins, assets,
costs an -rices o+ the #usiness to create a +le3i#le an -ro+ita#le o-eration"
Money is the #loo that +lo!s through the veins o+ a #usiness enter-rise"
In so$e cases, the $ain #usiness o-erators $ay leave the +inancial issues to
another -arty, such as an accountant +or a s$all enter-rise, or a chie+
+inancial o++icer or +inancial controller in a large enter-rise"
=o!ever, +inancial issues are the +ounation o+ a success+ul #usiness
enter-rise, an a #usiness cannot #e evelo-e an o-erate success+ully
!ithout an unerstaning o+ the +inancial issues involve an attention to
these issues"
1.7.4. 7nertaint$ & fle)ibilit$
The +uture is inherently uncertain, an events rarely un+ol e3actly as
e3-ecte"
2le3i#ility is +una$ental to survival !hen une3-ecte changes occur"
16
2or e3a$-le, uring a -rolonge -erio o+ slo! sales, $oving to alternative
-re$ises !ith a lo!er rent coul #e use to reuce costs" =o!ever, this
o-tion !oul not #e availa#le i+ the -ro-erty !as occu-ie !ith a long<ter$
lease"
As another e3a$-le, !here a long<ter$ agree$ent to su--ly a custo$er
s-eci+ie a +i3e -rice, this coul cause -ro#le$s i+ the -rice o+ ra! $aterials
rose shar-ly"
In general, any situation that cannot #e altere in a short or $eiu$ ter$
ti$e+ra$e reuces the +le3i#ility o+ the #usiness to aa-t to change
conitions, an coul lea to serious -ro#le$s i+ averse events occurre"
Maintaining alternative su--liers, ae&uate cash an stock levels an stan<
#y creit +acilities coul #e use to reuce the e3-osure to une3-ecte
changes"
20
. Elements of Business
.1. *ecor(+eeping & ,ccounts
A #usiness cannot #e $anage e++ectively unless accurate an u-<to<ate
in+or$ation is reaily availa#le"
This coul inclue the +ollo!ing in+or$ation
/usto$er etails, such as na$e an shi--ing aress"
7etails o+ orers -lace, such as the ite$ escri-tion an shi--ing
etails"
Inventory an stock lists"
7etails o+ arrange$ents in -lace, such as regular $aintenance
contracts"
5rouct s-eci+ications an in+or$ation"
2inancial recors inclue etails o+ -ay$ents, recei-ts, assets hel, -urchase
an sale transactions, an other ite$s such as e-reciation rates"
In a cash +lo!<#ase service #usiness, accounts $ay su--ly re+lect cash
recei-ts an cash -ay$ents, !ith net -ro+it #eing the e3cess o+ recei-ts a#ove
-ay$ents"
Dhen assets are hel !ithin the #usiness, aitional co$-le3ity arises +ro$
e-reciation values, intangi#le assets an so on"
2.1.1. 7ses of 'ounts
Accounting an other +inancial recors are neee to e++ectively $anage an
o-erate a #usiness"
This $ay take the +or$ o+ re-orts o+ transactions that have occurre over
various ti$e -erios"
Re-orts o+ non<+inancial in+or$ation , such as the nu$#er o+ ne! custo$ers,
the nu$#er o+ custo$er cancellations, an the volu$es o+ goos -rouce,
$ay also #e neee on a regular #asis"
21
A +ull set o+ +inancial state$ents $ay #e -rouce once or t!ice a year,
although the key in+or$ation !oul generally nee to #e generate on a
$onthly #asis"
7e-ening on the ty-e o+ #usiness an legal structure, +inancial state$ents
$ay nee to #e loge !ith stock e3changes, govern$ent regulators, an
issue to shareholers"
2inancial state$ents are also analyse in situations !here other #usinesses
are -urchase"
2.1.2. Basi 'ounts
Basic accounts re&uire a recor o+ each transaction that has occurre, along
!ith t!o +inancial state$ents"
The +inancial state$ents are a #alance sheet, an a -ro+it<an<loss state$ent"
Balance Sheet
The Balance Sheet contains a list o+ the assets o+ the #usiness, !hich are any
ite$s o+ value o!ne #y the #usiness"
,ia#ilities are any a$ounts that are o!e, !hich $ainly co$-rises e#ts
such as #ank loans" The i++erence #et!een the t!o +igures is the net assets
o+ the #usiness"
The #alance sheet a--lies at a -articular -oint in ti$e"
2or e3a$-le
Balance Sheet as at 30
th
Fune 2002
Assets
%&ui-$ent 200
Ra! Materials 30
/ash at #ank 8
Total Assets 238
22
,ia#ilities
Bank loan 2*
Averra+t 3
Total ,ia#ilities 28
4et Assets 210
In this case there are three assets, incluing e&ui-$ent, ra! $aterials an
cash on e-osit at a #ank" The total value o+ the assets is G238"
,ia#ilities inclue a #ank loan an a che&ue account overra+t, !ith a total
value o+ G28"
The total assets, su#tracting total lia#ilities, leas to a net assets +igure o+
G210"
The net assets +igure is also kno!n as e&uity, shareholerCs e&uity or
shareholerCs +uns"
Profit-and-Loss statement
The -ro+it<an<loss state$ent recors all transactions that have occurre over
a -erio o+ ti$e"
This inclues all -ay$ents receive, an -ay$ents $ae"
A +ull accounting -ro+it<an<loss state$ent inclues ite$s such as
e-reciation, !hich a--ly to the change in the value o+ assets"
These ite$s o not re+lect actual cash transactions, ho!ever they o a++ect
the value o+ the #usinessCs assets, an so they a++ect the -ro+it or loss"
=o!ever, in $any cases these ite$s are not o+ signi+icant si@e, or can #e
consiere as a se-arate issue +ro$ the o-eration o+ the #usiness"
Hsing a #asic accounting a--roach, a recor o+ all inco$e an -ay$ents is
su++icient to recor the changes in cash levels +ro$ the o-eration o+ the
#usiness"
23
2or e3a$-le
5ro+it . ,oss State$ent
30
th
Fune 2001 to 30
th
Fune 2002
Revenue
Inco$e +ro$ sales 81
%3-enses
Rent 18
Htilities (gas, electricity) 3
5ay$ents to e$-loyees 1*
Materials 22
Interest 2
Ta3 3
Total %3-enses )2
4et Inco$e 6
In this e3a$-le, the inco$e a$ount is G81, !hich is the a$ount receive
+ro$ sales"
%3-ense -ay$ents total to G)2"
The net inco$e is the cash receive less the cash -ay$ents, !hich is e&ual to
G6"
These #alance sheet an -ro+it<an<loss state$ents use a cash<#ase
accounting $etho"
This accurately recors the +inancial -osition o+ the #usiness over the -erio
o+ the state$ents"
=o!ever, there are so$e li$itations !ith this a--roach"
20
The $a9or li$itation !ith this cash<#ase $etho is that it oes not recor
the e-reciation in the value o+ the e&ui-$ent"
In this e3a$-le, e&ui-$ent !ith a value o+ G200 is recore in the #alance
sheet"
I+ the value o+ the e&ui-$ent ecline to G110 over the year, then this !oul
re-resent a G20 loss to the #usiness"
This a$ount coul #e inclue as a e-reciation e3-ense, to $ore accurately
re+lect the net -ro+it o+ the #usiness over the -erios"
Most -hysical assets ecline in value over ti$e, an a e-reciation e3-ense is
generally calculate #y allocating the cost o+ the asset over the usa#le li+e o+
the e&ui-$ent"
This is #roaly si$ilar to recoring a eclining in $arket value, although the
accounting a--roach is a #ook<kee-ing a--roach, rather than a $arket<value
a--roach"
The other $a9or i++erence #et!een a cash accounting syste$ an a +ull set
o+ accounts is the accrual accounting $etho"
This a--roach recors each transaction in the -erio that it a--lies to, rather
than the ate that the actual -ay$ent is $ae"
Accrual accounting -rouces a $ore accurate recor o+ the changes in value
uring a -articular -erio than cash<#ase accounting"
=o!ever, accrual accounting is $ore co$-le3 to i$-le$ent an reconcile,
an $any organisations use cash accounting instea"
Basic accounts such as these !oul generally #e suita#le +or $anaging
#usinesses that i not involve large ite$s o+ e&ui-$ent, an +or the -ur-oses
such as #ank loans"
Basic accounts !oul not #e suita#le +or ca-ital<intensive inustries
involving signi+icant e&ui-$ent or -lant values, or +or +or$al re-orting to
regulatory authorities an stock e3changes"
2.1.3. Double*Entr$ Boo66eeping
Accounting is #ase on a syste$ kno!n as ou#le<entry #ookkee-ing"
2*
This !as +irst evelo-e #y a $onk to recor lists o+ stocks an transactions
at a $onastery, aroun the year (>> check)"
Dith ou#le<entry #ookkee-ing, a set o+ accounts it hel"
An account $ay corres-on to a #ank account, or $ay si$-ly recor a -ool
o+ +uns set asie +or a -articular -ur-ose"
All transactions are entere t!ice, as a trans+er +ro$ one account to another"
2or e3a$-le, $oney trans+erre +ro$ one #ank account to another !oul #e
recore as t!o entries, one in the account that the $oney !as trans+erre
+ro$, an another in the account that the $oney !as trans+erre to"
This !oul re-resent an increase in the value o+ one account, an a reuction
in the value o+ the other account"
Bank state$ents are -rinte +ro$ the -oint o+ vie! o+ the #ank, !hich is the
o--osite o+ the e-ositorCs -osition"
7ue to this, the co$$on usage o+ :creit; an :e#it; is the o--osite o+ the
strict accounting usage"
In accounting ter$s, a :e#it; is a transaction that increases the value o+ an
account, !hile a :creit; is a transaction that reuces the value o+ an account"
7ou#le<entry #ookkee-ing is not necessary in orer to accurately recor the
+inancial transactions o+ a #usiness, an -rouce +inancial state$ents"
=o!ever, accounting so+t!are, #anking an the accounts o+ large enter-rises
o+ten use the ou#le<entry $etho"
2.1.4. 'rual 'ounting
Transactions are recore using a cash<#ase $etho or an accrual $etho"
This a--lies !hether a single<entry or ou#le<entry $etho is use to recor
the transactions"
Hner cash<#ase accounting, a transaction is recore on the ate that the
-ay$ent is $ae or receive"
2)
In the case o+ che&ue -ay$ents, the ate recore !oul generally #e the
ate that the che&ue !as issue, although the che&ue $ay not #e -resente
an clear until so$e ti$e in the +uture"
Hner accrual<#ase accounting, transactions are recore !hen they #eco$e
e++ective, rather than !hen the cash actually changes hans"
Accrual accounting recors transactions on ates relating to changes in value,
!hile cash accounting recors transactions on the ate that the cash +lo!
occurs"
2or $any cash -ay$ents, there is no i++erence #et!een the t!o syste$s"
Although it !oul #e an unusual case in -ractice, an e3a$-le o+ an accrual
!oul #e the rent on a -ro-erty that !as -ai annually"
Hner cash<#ase accounting, no transaction !oul #e recore +or the +irst
eleven $onths, !ith the +ull rent -ay$ent #eing recore in the t!el+th
$onth"
Accu-ying the #uiling +or si3 $onths !oul e++ectively #e an e3-ense e&ual
to hal+ the yearly rent, even though the -ay$ent itsel+ !oul not #y ue until
the t!el+th $onth"
Accrual accounting !oul hanle this situation #y recoring a transaction in
each $onth +or the rent that !as use that $onth, even though the cash
-ay$ent !oul not occur until the en o+ the year"
A si$ilar situation arises !hen !ork has #een -er+or$e an an invoice has
#een raise to #e -resente to the client, #ut the -ay$ent itsel+ has not #een
receive"
Accrual accounting $ore accurately re+lects the value o+ the #usiness an the
value o+ e3-enses an inco$e across -erios o+ ti$e than cash<#ase
accounting"
=o!ever, accrual accounting is $ore co$-le3 to i$-le$ent an reconcile
than cash<#ase accounting"
Also, accrual accounting looses the link #et!een the accounting recors an
the cash availa#le !ithin #ank +acilities"
This $ay lea to cash +lo! -ro#le$s in so$e circu$stances, an !oul
-articularly a++ect a #usiness that inclue large in+lo! an out+lo!
-ay$ents, rather than a steay strea$ o+ regular -ay$ents"
28
2or e3a$-le, issuing a large volu$e o+ invoices !oul lea to a large inco$e
+igure #eing -oste uner an accrual syste$, ho!ever no cash !oul actually
have #een receive, an cash !oul not #e availa#le +or the -ay$ent o+
e3-enses"
Dhen accrual accounting is use, se-arate cash +lo! recors $ust #e
$aintaine +ro$ the accounting recors to -ro-erly $anage cash +lo!"
2.1.5. /inanial & 'ounting +onepts
Cash transfers & value transfers
2inancial state$ents involve a se-aration #et!een the conce-t o+ :cash; an
the conce-t o+ :value;"
/ash re-resents holings in #ank accounts"
'alue re-resents a holing o+ value that the #usiness o!ns, an inclues
cash, e&ui-$ent, #uilings, an e3-ecte -ay$ents +ro$ custo$ers"
In so$e transactions, cash is trans+erre #ut there is no trans+er o+ value"
In other events, value is trans+erre #ut there is no trans+er o+ cash"
An e3a$-le o+ the +irst situation occurs !hen an ite$ o+ e&ui-$ent is
-urchase"
/ash leaves the #usiness an the cash #alance ecreases"
=o!ever, the value o+ the e&ui-$ent re-laces the value o+ the cash -ai out,
an there is no change in total value"
This re-resents a transaction that changes the #usinessCs assets +ro$ one +or$
to another, !ithout increasing or ecreasing total value"
In this e3a$-le, cash is e3change +or the e&ui-$ent"
An e3a$-le o+ the o--osite situation is the reuction in the value o+ the
e&ui-$ent"
In this situation, there is a change in value, ue to the reuction in the value
o+ the e&ui-$ent"
21
=o!ever, no transaction occurs, an there is no trans+er o+ cash an no
change in the cash #alance"
The t!o se-arate conce-ts o+ cash trans+er an value trans+er are the #asis o+
the +inancial analysis o+ a #usiness, an are the #asis on !hich the +inancial
accounts are -re-are"
Bookkeeping allocations s! market values
A secon issue relates to the #ookkee-ing a--roach use in accounting"
In so$e situations, accounting o-erates on the #asis o+ counting ite$s in
various !ays, that o not re+lect either cash trans+ers or value trans+ers"
This is a thir situation that is #ase on ensuring that all ite$s are +ully
recore, even through the recor $ay not re+lect a cash or value situation"
7e-reciation is an e3a$-le o+ this"
A $achine $ay #e -urchase +or G100, !ith a use+ul li+e o+ ten years"
Hner straight<line e-reciation, an e3-ense o+ G10 !oul #e recore in
each year"
The asset !oul #e liste in the #alance sheet !ith a value o+ G100 in the +irst
year, G60 in the secon year, G10 in the thir year an so on"
This is one to $atch the e3-ense in each year against the inco$e -rouce
+ro$ the $achine in the sa$e year"
=o!ever, the G10 a$ount is a #ookkee-ing entry, it oes not $atch a cash
transaction, an it $ay not $atch a value trans+er"
This is an i$-ortant issue in the sense that entries in +inancial state$ents,
such as the values liste +or assets, $ay #e &uite i++erent +ro$ $arket
values"
An alternative vie! o+ e-reciation is that the e-reciation e3-ense re+lects
the reuction in the $arket value o+ the e&ui-$ent, !hile the entry in the
#alance sheet re+lects the ne! $arket value +ollo!ing the ecline +or that
year"
This is not strictly the a--roach that is use in #ookkee-ing"
26
=o!ever, !hen the e-reciation rate a--ro3i$ately e&uals the ecline in
$arket value, the resulting +igures $ay #e si$ilar"
2.1.!. /inanial #tatements
(>> check accounting e+initions)
2inancial state$ents are -re-are accoring to a set o+ accounting stanars"
These stanars are set #y a national accounting authority, an are etaile
an rigi in e+ining the !ay in !hich a !ie range o+ iniviual transactions
are recore in the accounts"
=o!ever, in $any situations there is sco-e to classi+y a$ounts in several
!ays, or to -er+or$ calculations using a nu$#er o+ alternative $ethos, an
these i++erences can have a signi+icant #earing on the overall structure o+ the
accounts"
Accounting stanars vary signi+icantly +ro$ -lace to -lace an +ro$ ti$e to
ti$e"
Auite accounts are re&uire +or +or$al re-orting to regulatory authorities,
+or re-orting to stock e3changes, an +or in+or$ation su--lie to investors"
The auit -rocess is conucte #y ine-enent auitors, an $ay #e
-er+or$e #y accounting +ir$s"
The auit -rocess inclues the +ollo!ing ste-s
Revie!ing iniviual transactions at rano$"
Revie!ing the !ay in !hich $a9or ite$s are allocate in the
accounts"
/hecking that ae&uate stanars e3ist +or recoring transactions,
reconciling in+or$ation sources an -re-aring +inancial state$ents"
%nsuring that the +inancial state$ents are -re-are in a !ay that is
consistent !ith the accounting stanars"
30
Auite accounts inclue a signe state$ent #y the auitors that they have
revie!e the -re-aration o+ the accounts, an that in their o-inion the
accounts have #een -re-are in a !ay that is consistent !ith the accounting
stanars"
The -ur-ose o+ the auit -rocess is to check that the +igures that are -resente
are an accurate re+lection o+ the transactions that actually occurre uring the
-erio"
The auit oes not involve $aking 9uge$ents a#out the historical results or
+uture -ros-ects o+ the #usiness, an it oes not generally asses the relevance
o+ the valuations a--lie to assets"
A se-arate irectorCs eclaration is re&uire in so$e re-orting situations" The
irectorCs eclaration is a signe state$ent to the e++ect that, in the irectorCs
o-inion, the co$-any !ill #e a#le to $eet is e#ts as an !hen they +all ue"
This eclaration is intene +or the use o+ leners an creitors to the
co$-any, as in+or$ation regaring the on<going via#ility o+ the #usiness"
=o!ever, accounts are generally -re-are &uarterly or hal+<yearly, an the
in+or$ation $ay not #eco$e availa#le +or several $onths"
In -ractice, a co$-any can change +ro$ a sta#le +inancial -osition to near
#ankru-tcy in a $atter o+ $onths, an the irectorCs eclaration -rovies
little assistance to leners"
The -ri$ary +inancial state$ents are the #alance sheet, -ro+it<an<loss
state$ent, an the cash +lo! state$ent"
2.1.!.1. Balane #.eet
The #alance sheet recors the assets an lia#ilities o+ the #usiness at a certain
-oint in ti$e"
The assets inclue all -hysical -ro-erty such as lan an #uilings,
e&ui-$ent, -rouction +acilities, an cash holings"
In so$e cases, the value o+ intangi#le assets can also #e inclue" The value
o+ a ne!s-a-er $asthea, +or e3a$-le, can #e inclue as an asset !ithin the
#alance sheet"
31
,ia#ilities inclues all e#ts o!e #y the #usiness, such as #ank loans, #ons
an e#entures issue to investors, an a$ounts o!e to other co$-anies"
,ia#ilities also inclues other a$ounts that are o!e #y the #usiness, such as
-ay$ents ue that have not yet #een $ae, a$ounts o!e as a result o+ court
cases an so on"
The 4et Assets +igure recors the i++erence #et!een the value o+ the assets
an the value o+ the lia#ilities"
This is the net value o+ the #usiness in ter$s o+ the value o+ assets on the
#alance ate"
In theory, i+ all assets !ere sol at their liste value an all e#ts !ere re-ai,
the +inal a$ount re$aining !oul e&ual to the net assets +igure"
The net assets value is also kno!n as e&uity"
Assets
:/urrent assets; are assets that coul reaily #e converte into cash"
These assets are -art o+ the ongoing o-eration o+ the #usiness an !oul #e
e3-ecte to #e converte to cash !ithin one year"
These inclue
/ash on e-osit at a #ank"
Short<ter$ $oney invest$ents, such as 60<ay #ank #ills"
Accounts receiva#le I a$ounts that have #een #ille to custo$ers,
#ut have not yet #een receive"
:4on<current assets; are assets o+ a long<ter$, ca-ital nature that !oul not
#e e3-ecte to #e trae !ithin a one<year -erio"
These inclue
,an"
Builings"
5rouction +acilities"
Intangi#le assets
(oo!ill
32
:Intangi#le assets; are ite$s that the #usiness o!ns an that have value, #ut
are not -hysical o#9ects"
A license to o-erate in a certain $arket $ay #e an intangi#le asset"
The inclusion o+ intangi#le assets is li$ite to certain ite$s"
=o!ever, the value o+ the +ollo!ing ite$s can generally #e inclue !ithin
the #alance sheet as assets"
5atents, such as a -atent on ne! -rouction technology"
4e!s-a-er $astheas an $eia titles, such as the value o+ a !ell<
kno!n ne!s-a-er title"
,icenses, such as a licence to use a raio s-ectru$ +or $o#ile
tele-hone services"
Bran na$es an trae $arks"

:(oo!ill; is an accounting ite$ that is inclue !hen a #usiness -urchases
another #usiness"
Ariginally this ter$ relate to the regular custo$ers an re-utation that a
#usiness ha as a going concern"
This resulte in a higher -rice #eing -ai +or the #usiness, co$-are to the
ollar value o+ the stock an #uilings that !ere -urchase"
In -ractice, this relates to any situation !here the -rice -ai +or a #usiness
e3cees the value o+ the net assets o+ the #usiness #eing ac&uire"
This occurs in $ost -urchases o+ #usinesses"
2or e3a$-le, a cash +lo!<#ase service #usiness that leases e&ui-$ent an
-re$ises $ay have very +e! assets, although it $ay have signi+icant -ositive
cash +lo! an value as a #usiness"
In other cases a -re$iu$ is -ai ue to the increase value that is e3-ecte
+ro$ co$#ining the -urchase #usiness !ith the e3isting #usiness, or as a
$eans o+ gaining entry to a close or un+a$iliar $arket"
33
Hner the accounting stanars, goo!ill cannot #e inclue in the accounts
ue to internal generation" This ite$ is only inclue !hen a #usiness is
-urchase"

Money that is o!e to the #usiness is an asset"
This is ue to the +act that, !hen the a$ount is -ai, $oney is trans+erre
into the #usiness"
In the case o+ $oney that is ue +ro$ -rouct sales or services, this ite$ is
generally inclue as :accounts receiva#le; or :trae e#tors;"
In so$e cases, such as #ons that are trae on stock e3changes, the ite$
itsel+ can #e sol to another investor to recover the +uns, !ithout the original
#orro!er re-aying the e#t at that ti$e"
:Driting o++; an asset involves a#anoning the asset as lost"
This $ay occur !hen an asset is lost or estroye, such as an ite$ o+
e&ui-$ent #eing estroye #y +ire"
This situation also occurs !ith #a e#ts, !hen e++orts to recover the +uns
have +aile"
In this situation, the asset is re$ove +ro$ the #alance sheet"
An e3-ense is ae to the -ro+it<an<loss account to recor the +act that a
loss has #een recognise, an that the net asset +igure o+ the #usiness has
reuce #y that a$ount"
A !rite<u- occurs in that case that an asset has #een !ritten o++, #ut is later
une3-ectely recovere" In this case the asset is restore to the #alance sheet"
Lia"ilities
:/urrent lia#ilities; inclue e#ts that are -art o+ the regular o-eration o+ the
#usiness"
This inclues a$ounts that have a ter$ o+ less than one year, an a$ounts
that are re-aya#le at call"
This incluesE
30
Bank overra+ts"
Short<ter$ #ank loans, such as seasonal +inancing through i++erent
-erios o+ the year"
Accounts -aya#le I a$ounts that are ue +or -ay$ent, #ut have not
yet #een -ai"
5rovisions I a$ounts set asie +or s-eci+ic -ur-oses"
:4on<current lia#ilities; are a$ounts o+ a long<ter$ nature !oul not
nor$ally #e re-ai !ithin a year"
This inclues
Bank loans"
Bons an e#entures use to #orro! +uns +ro$ investors"
4on<current -rovisions"
:5rovisions; are a$ounts that are set arise +or s-eci+ic -ur-oses" 2or
e3a$-le, a -rovision $ay #e recore +or e$-loyee long<service leave"
This !oul a--ear as an entry uner lia#ilities"
I+ this a$ount !as +une #y cash, this +igure !oul #alance against -art o+
the cash recore uner the assets section"
2or e3a$-le
Assets
/ash 100
,i#ilities
5rovision +or long<service leave 20
4et Assets 10
3*
In this e3a$-le, the :-rovision +or long service leave; entry recors that +act
that G20 $ust #e carrie +or!ar an reserve +or s-eci+ic +uture -ur-oses,
even through it is not currently ue +or -ay$ent"
This #alances against the G100 o+ current cash, to result in a net +igure o+ G10
o+ +ree cash"
:/ontingent lia#ilities; are a$ounts that $ay #e ue +or -ay$ent i+ certain
circu$stances arise"
2or e3a$-le, a court case $ay currently #e in -rogress" I+ the result is
un+avoura#le, then a -ay$ent $ay #e ue"
In this case, the a$ount !oul #e recore as a lia#ility in the accounts, !ith
a note escri#ing the etails o+ the ite$"
#et Assets
The :net assets; +igure is the i++erence #et!een the total assets an the total
lia#ilities"
This +igure is so$eti$es recore as several se-arate reserves, such as an
asset<revaluation reserve, !hich $ay a--ear !hen an asset is re<value !ith
a ne! value"
4et assets are also kno!n as :shareholerCs +uns;, :shareholerCs e&uity; or
si$-ly :e&uity;"
The +ollo!ing e3a$-le -resents a sa$-le #alance sheet
3)
Balance Sheet
As at 30
th
Fune 2002
Assets
/urrent Assets
/ash on e-osit 2*
Accounts receiva#le 10
Total /urrent Assets 3*
4on</urrent Assets
5ro-erty, -lant . e&ui-$ent 200
5atents *0
Total 4on</urrent Assets 2*0
Total Assets 21*
,ia#ilities
/urrent ,ia#ilities
Bank Averra+t 12
Accounts -aya#le *
5rovision +or #a . ou#t+ul e#ts 1
Total /urrent ,ia#ilities 11
4on</urrent ,ia#ilities
Bank e#t 12*
Total 4on</urrent ,ia#ilities 12*
Total ,ia#ilities 103
ShareholerCs %&uity 102
38
Asset $evaluations
In general, assets that are -urchase are -lace on the #alance sheet at their
cost value"
%ach -erio a e-reciation e3-ense is inclue in the -ro+it<an<loss
state$ent, !hile the value o+ the asset is reuce #y the e&uivalent a$ount"
=o!ever, in so$e cases the value o+ an asset $ay rise or +all #y signi+icant
a$ounts, an the value o+ the asset in the #alance sheet $ay #e change"
This ha--ens -articularly !ith -ro-erties, invest$ents such as holings o+
shares, in !ith +oreign assets or lia#ilities ue to changes in the e3change
rate"
The ne! valuation $ay #e #ase on an ine-enent valuation, a calculation
such as a share -rice or currency e3change rate, or a :irectorCs valuation;
!hich is an esti$ate o+ the value $ae !ithin the co$-any"
In these cases, the value o+ the asset on the #alance sheets is u-ate to
re+lect the ne! value"
(>> check inclusion in 5J, account)
2.1.!.2. 3rofit & 8oss #tatement
The -ro+it an loss state$ent recors the inco$e an e3-enses that occurre
uring a -erio"
This inclues all cash transactions, an also ite$s re+lecting the change in the
value o+ +i3e assets"
(>> check accounting treat$ent o+ asset revaluations I -Jl entry yesJno)
7e-reciation is recore as an e3-ense, re+lecting the reuction in the value
o+ assets uring the -erio"
7e-reciation oes not re-resent an actual cash transaction, an a--lies to the
entire -erio, rather than a s-eci+ic ate"
A$ortisation is a si$ilar e3-ense to e-reciation, #ut a--lies to intangi#le
assets such as goo!ill, -atents an licenses"
31
Dhere accrual accounting is use, the inco$e an e3-enses !ill #e inclue
on the ate that e3-ense !as use or the inco$e !as #ille, rather than the
ates that the cash -ay$ents !ere $ae"
The -ro+it<an<loss state$ent can #e -resente in a variety o+ !ays, ho!ever
the +ollo!ing e3a$-le -resents one +or$at
36
Profit & Loss Statement
1
st
Fuly 2001 to 30
th
Fune 2002
Revenue 181
A-erating %3-enses
/ost o+ goos sol 18
(eneral an a$inistrative e3-enses 18
Marketing an istri#ution e3-enses 10
Total A-erating %3-enses 116
%arnings #e+ore interest, ta3, e-reciation *2
. a$ortisation
7e-reciation 13
A$ortisation 2
%arnings #e+ore interest . ta3 38
Interest 3
Ta3 12
4et 5ro+it A+ter Ta3 22
00
:Revenue; is also re+erre to as :Sales; or :Inco$e;"
This a$ount re+lects the cash -ay$ents that !ere receive #y the #usiness
uring the -erio"
The :cost o+ goos sol; +igure inclues ra! $aterials, -rouction costs,
salaries an all e3-enses that relate irectly to the goos -rouce"
The :general an a$inistrative e3-enses; inclues rent, salaries, an other
a$inistrative costs that relate to o-erating an $anaging the #usiness an
o not irectly relate to the volu$e o+ goos -rouce"
Although interest -ai on e#t is o+ten a signi+icant e3-ense, a #usiness $ay
also receive s$all a$ounts o+ interest +ro$ cash e-osits o+ !orking ca-ital"
In these cases, the :net interest; +igure is e&ual to the interest -ai, $inus the
interest receive"
In the general use o+ the !or :interest; in the accounts an in analysis, this
re+ers to interest -ai on e#t, not interest receive"
The :net assets; +igure o+ the #alance sheet at the en o+ the -erio shoul
e&ual the net assets +igure at the #eginning o+ the -erio, -lus the net -ro+it
+ro$ the -ro+it<an<loss state$ent"
7i++erences are ue to e&uity ca-ital raise or -ai out #y the #usiness"
This inclues iviens -ai to shareholers, ca-ital istri#ute +ro$ the
#usiness to shareholers, an ne! ca-ital raise +ro$ investors to increase
the assets !ithin the #usiness"
Raising or re-aying e#t $ay a++ect the total assets an total e#ts +igures,
#ut oes not a++ect the net assets +igure"

2.1.!.2.1. Depreiation
The :e-reciation; e3-ense is uni&ue in several res-ects"
7e-reciation is not a cash transaction, an oes not re-resent an in+lo! or
out+lo! o+ cash"
01
=o!ever, it oes re-resent an out+lo! o+ value, ue to the ecrease in the
value o+ the e&ui-$ent"
This reuces the net assets +igure, #ut not the cash #alance"
Also, e-reciation a--lies to a -erio o+ ti$e, rather than a s-eci+ic ate"
Inco$e, e3-enses, -urchases an sales all re-resent transactions that occur on
a -articular ate"
In contrast, e-reciation re+ers to a ecline in value that has occurre
continuously over a -articular -erio o+ ti$e"
The total inco$e an other ite$s in the -ro+it an loss account also a--ly
over a -erio o+ ti$e, ho!ever these ite$s si$-ly involve su$$ing a range
o+ iniviual transactions"
There are t!o vie!s o+ the $eaning o+ e-reciation"
Accounting is concerne !ith #ookkee-ing, rather than recoring true $arket
values or value create or estroye"
Hner an accounting vie!-oint, e-reciation involves allocating the cost o+
an ite$ o+ e&ui-$ent across a nu$#er o+ -erios"
2or e3a$-le, a -iece o+ e&ui-$ent $ay cost G*0 an have a use+ul li+e o+
+ive years"
Hner the accounting vie!, a straight<line e-reciation a$ount o+ G10 -er
year is si$-ly a !ay o+ allocating the cost o+ the e&ui-$ent across the sa$e
-erios that it is use +or -roucing inco$e"
This $atches the inco$e a$ount each year !ith the e3-ense a$ount +or the
year"
Another vie! relates to the $arket value o+ the e&ui-$ent"
Hner this vie!, the e-reciation is a recor o+ the ecline in the value o+ the
e&ui-$ent"
This is an e3-ense, as it re+lects a loss in the assets o+ the #usiness"
Both vie!s re+lect si$ilar results !hen the $arket value eclines in
a--ro3i$ately the sa$e -attern as the e-reciation scheule"
02
Calculating a depreciation e%pense
7e-reciation $ay #e calculate using a nu$#er o+ $ethos"
A :straight<line; e-reciation a--roach allocates a constant e-reciation
e3-ense to each -erio"
This is a si$-le a--roach, an $ay also have a #ene+it in -roucing
consistent results across -erios"
The e-reciation e3-ense +or an asset can #e calculate in this case using the
+ollo!ing +or$ula
life useful estimated of years of Number
asset the of Cost
on Depreciati
5re-aring accounts $ay involve aing the e-reciation e3-ense as an
e3-ense ite$, an reucing the value o+ that asset in the #alance sheet #y the
a$ount o+ the e-reciation e3-ense"
Alternative $ethos $ay inclue a :eclining #alance; $etho, !hich
reuces the value #y a +i3e -ercentage each -erio (>> check), an a :su$
o+ the years igits; $etho"
The su$<o+<the<years<igits $etho involves aing each year in the use+ul
li+e, an -ro-ortioning the asset value accoring to the year" (>> check)
2or e3a$-le, in the case o+ an asset !ith a use+ul li+e o+ +ive years, the
+ollo!ing +igures $ay a--ly"
* 0 3 2 1
*
1
+ + + +
t cos asset on depreciati Year
* 0 3 2 1
0
2
+ + + +
t cos asset on depreciati Year
* 0 3 2 1
3
3
+ + + +
t cos asset on depreciati Year
03
* 0 3 2 1
2
0
+ + + +
t cos asset on depreciati Year
* 0 3 2 1
1
*
+ + + +
t cos asset on depreciati Year
These alternative $ethos $ay allocate a larger -ro-ortion o+ the
e-reciation e3-ense to early years than to later years"
This a--roach $ay result in a conservative asset value, !ith large asset value
ecreases occurring in early years, an $ay also re+lect the $arket value o+
the asset $ore closely than a straight<line a--roach"
=o!ever, the straight<line a--roach $ay have a #ene+it o+ si$-licity, an is
also consistent +ro$ one -erio to the ne3t"
2.1.!.2.2. +apital transations
/a-ital transactions o not a--ear in the -ro+it an loss state$ent, as they o
not re+lect an increase or ecrease in shareholerCs assets"
In the case o+ -urchasing so$e e&ui-$ent !ith cash, +or e3a$-le, the cash
#alance !oul ecrease, the value o+ -ro-erty, -lant an e&ui-$ent !oul
increase, an the total assets !oul #e unchange"
In cases !here a -urchase !as +une #y e#t, the value o+ the total assets
!oul increase"
=o!ever, the value o+ the total lia#ilities !oul also increase #y the sa$e
a$ount, an the net assets !oul not change"
In cases o+ e&uity #eing raise or ca-ital istri#utions to shareholers, the net
assets +igure !ithin the #alance sheet !ill change"
=o!ever, this re+lects the trans+er o+ +uns into or out o+ the #usiness, rather
than an increase or ecrease in assets ue to o-erations"
/a-ital transactions inclue the +ollo!ing ite$sE
5urchases an sales o+ -ro-erty, e&ui-$ent an other +i3e assets"
00
5ay$ent o+ iviens"
Raising an re-aying e#t"
Raising e&uity an e&uity istri#utions to shareholers"
=o!ever, these ite$s !oul a--ear in the cash +lo! state$ent, as they $ay
involve trans+ers o+ cash"
2.1.!.3. +as. /lo5 #tatement
The cash +lo! state$ent recors cash transactions that occurre !ithin the
-erio"
This $ay #e &uite i++erent to the -ro+it<an<loss state$ent"
/a-ital transactions, such as e&ui-$ent -urchases, are inclue in the cash
+lo! state$ent #ut not in the -ro+it<an<loss state$ent"
In contrast, non<cash ite$s such as e-reciation are inclue in the -ro+it<
an<loss state$ent, #ut not in the cash +lo! state$ent"

The cash +lo! state$ent $ay a--ear in various +or$s"
Ane +or$at grou-s the ite$s into three categories"
These areE
/ash +lo! +ro$ o-erations (eneral inco$e an e3-enses +ro$
the o-eration o+ the #usiness"
/ash +lo! +ro$ invest$ent activities /a-ital transactions such as the
-urchase an sale o+ assets,
evelo-$ent o+ ne! +acilities etc"
/ash +lo! +ro$ +unraising activities 4e! e#t raise, -lus ne! e&uity
raise, less e#t re-ai, less ca-ital
istri#utions to shareholers, less
iviens -ai"
0*
In this conte3t, :invest$ent activities; relates to #usiness invest$ents such as
constructing +acilities, rather than +inancial invest$ent such as -urchasing
shares"
Invest$ent activities !oul inclue #uiling ne! +acilities an +uning $a9or
-ro9ects"
The +ollo!ing e3a$-le -resents one -ossi#le +or$at o+ a cash +lo!
state$ent"
0)
Statement of cash flows
30
th
Fune 2001 to 30
th
Fune 2002
A-ening cash #alance 80
/ash +lo!s +ro$ o-erating activities
Sales inco$e 10
5ay$ents to su--liers (20)
5ay$ents to e$-loyees (2*)
Builing occu-ancy costs (1*)
Ather o-erating cash +lo!s *
Total /ash +lo!s +ro$ o-erating activities 2*
/ash +lo!s +ro$ investing activities
/onstruction o+ ne! +acilities (08)
Total /ash +lo!s +ro$ investing activities (08)
/ash +lo!s +ro$ +uning activities
4et e#t raise 8*
4et e&uity raise (2*)
7iviens -ai (10)
Total /ash +lo!s +ro$ +uning activities 00
Total cash +lo! 11
/losing cash #alance 62
08
2.1.!.4. #tatement of +apital Transfers
A state$ent o+ ca-ital trans+ers is not a stanar +inancial state$ent"
=o!ever, a state$ent o+ ca-ital trans+ers $ay #e use+ul in $anaging the
#usiness, an -resenting a clear -icture o+ the ca-ital actions o+ the #usiness
uring the -revious -erio"
The stanar +inancial state$ents o+ the #alance sheet an -ro+it<an<loss
state$ent are #uilt on the +ra$e!ork o+ accounting"
The $a9or -ur-ose o+ accounting is to recor the holings an trans+ers o+
assets"
Dhile this is an essential -art o+ #usiness an is a use+ul in-ut into #usiness
$anage$ent, it $ay not al!ays -resent in+or$ation in a !ay that sho!s a
clear -icture o+ the #usiness an its recent o-erations"

The three $a9or +inancial state$ents have the +ollo!ing usesE
Balance Sheet The +inancial structure o+ the #usiness, an itCs
current holings"
5ro+it an ,oss State$ent The net inco$e, -ro+it or loss involve +ro$
o-erating the #usiness" This in+or$ation can #e
use to eter$ine $argins"
/ash 2lo! State$ent The +lo!s o+ cash into an out o+ the #usiness"
This can #e use in the $anage$ent o+ cash
+lo!"
A state$ent o+ ca-ital trans+ers can #e co$-ile using in+or$ation the other
three state$ents"
The #alance sheets -resents a static vie! at a certain -erio o+ ti$e, !hile the
other three state$ents -resent in+or$ation regaring +lo!s in the +ollo!ing
!aysE
5ro+it an loss state$ent 2lo!s o+ value to or +ro$ the shareholers"
01
/ash +lo! state$ent 2lo!s o+ cash"
/a-ital trans+ers state$ent 2lo!s o+ ca-ital, incluing trans+ers o+
value +ro$ one +or$ to another"
This coul #e -resente in a nu$#er o+ !ays" The +ollo!ing +or$at is one
e3a$-le"
06
Statement of capital transfers
30
th
Fune 2001 to 20
th
Fune 2002
Item Opening
Value
Net
Change
Closing
Value
Assets
Plus Capital
Expenditure
Less
Depreciation
Less Sales
of Prop,
Plant
E!uipment
Propert",
Plant
E!uipment
#$ %$ %& & '($) *$
Cash flo+
from
operations
Net Capital
Actions
Cash (& # '%) , %(
Other Assets (% '-) .
/otal Assets ($* '*) ($$
Lia0ilities
De0t -$ '($) %$
Other
Lia0ilities
1 % ,
/otal
Lia0ilities
-1 '#) %,
Plus Net
Profit 2rom
Operations
Plus Net
E!uit"
3aised
Less
Di4idends
Paid
Shareholder5s
E!uit"
*- & ( & ( *1
*0
2.1.7. 'ounting 4ssues
2.1.7.1. +apitalise( E)penses
(eneral e3-enses re-resent an out+lo! o+ value +ro$ the #usiness" 2or
e3a$-le, -ay$ents $ae +or rent re-resent a +lo! o+ value out o+ the
#usiness"
In the case o+ ca-ital trans+ers, such as -urchasing e&ui-$ent, this re-resents
a cash -ay$ent, #ut oes not re-resent an out+lo! o+ value +ro$ the #usiness,
as the e&ui-$ent co$es into the #usiness in -lace o+ the cash that has +lo!e
out"
A si$ilar issue can arise in other circu$stances"
2or e3a$-le, e3-enses incurre in constructing a #uiling o not re-resent an
out+lo! +ro$ the #usiness, #ecause the co$-lete #uiling !oul have a
value that !oul o++set the cash that !as s-ent"
In these cases, the -ay$ents !oul not #e inclue in the -ro+it an loss
state$ent"
Instea, the -ay$ent a$ounts are ae to the #alance sheet as an asset"
This is kno!n as ca-italising e3-enses"
The asset !oul then #e e-reciate in the sa$e !ay as assets that !ere
-urchase"
This ena#les the #alance sheet to re+lect the asset that has #een create, an
-revents the -ro+it an loss state$ent +ro$ suggesting that large e3-enses
!ere incurre, !hen in +act the -ay$ents !ere e++ectively a ca-ital trans+er,
rather than a loss"
=o!ever, this is a controversial area"
/a-italising e3-enses reuces the e3-enses in the -ro+it an loss account, an
so this $akes the -ro+it a--ear to #e higher than it !oul #e i+ -ay$ents !ere
e3-ense through the -ro+it an loss account rather than #eing ca-italise"
This a--roach accurately re+lects the results o+ the activity !hen a genuine
asset is create"
*1
=o!ever, in so$e cases a !ie range o+ e3-enses $ay #e ca-italise,
ranging +ro$ avertising +ees to interest -ay$ents, !ith the ai$ o+ $aking
the -ro+it a--ear to #e larger than it actually !as"
The -ur-ose o+ this $ay #e to increase the re-orte -ro+it to $ake the
#usiness a--ear $ore attractive !hen o++ering the #usiness +or sale, ealing
!ith #anks, an ealing !ith investors"
In #roa -rinci-le, ca-italising e3-enses $ay accurately re+lect the situation
!hen the e3-enses lea irectly to the creation o+ an ienti+ia#le asset that
can #e use to -rouce inco$e, such as a #uiling or a -atenta#le -rouct"
There is no clear<cut i++erence #et!een ca-italise -ay$ents an e3-enses,
an a su#9ective ecision $ust #e $ae in each case"
A conservative a--roach $ay involve e3-ensing all -ay$ents an avoiing
ca-italising e3-enses"
This a--roach $ay avoi incluing assets !ithin the #alance sheet that $ay
have a &uestiona#le value, an $ay not #e a#le to #e sol"
In turn, this a--roach $ay -lace the #usiness in a $ore secure -osition to
!ithstan une3-ecte events"
=o!ever, in cases such as the construction o+ actual #uilings, a
ca-italisation o+ e3-enses $ay #e $ore suita#le"
2.1.7.2. 'ounts vs. 3.$sial 2ol(ings
In a #asic +inancial $anage$ent syste$, accounts $ay #e ke-t that
corres-on to cash recei-ts an actual #ank accounts"
=o!ever, in $ore co$-le3 syste$s, $ulti-le accounts $ay #e $aintaine
that o not corres-on to iniviual cash #alances or #ank accounts"
Dith +uns set asie +or s-eci+ic -ur-oses, +or e3a$-le, a +un $ay #e
$aintaine +or $aintenance e3-enses, !hile a se-arate +un is $aintaine +or
utility costs such as gas an electricity e3-enses"
These +uns coul #e recore as se-arate accounts, !ith creit an e#it
entries an even trans+ers +ro$ one account to the other"
*2
=o!ever, #oth +uns $ay #e ke-t !ithin a single #ank account, !ith the
#ank account holing all transactions an #alances that a--lie to #oth
accounts"
%3-enses are generally allocate to i++erent accounts +or re-orting an
$anage$ent -ur-oses"
2or e3a$-le, an account $ay #e ke-t +or re+uns +or a$age or returne
ite$s, !hile a se-arate account $ay #e ke-t +or -ay$ents to su--liers"
Both accounts $ay #e $aintaine as se-arate accounts, although che&ues
$ay #e ra!n on a single #ank account"
In this case, transactions +ro$ #oth accounts !oul all #e -rocesse through
a single #ank account"
Accounting syste$s can #eco$e e3tre$ely co$-le3, !ith so$e large
#usinesses $aintaining thousans o+ accounts, incluing su#<accounts !ithin
$a9or accounts"
Alternatives inclue $aintaining a si$-le list o+ accounts, an tagging
iniviual transactions !ith aitional in+or$ation +or re-orting -ur-oses"
This arrange$ent allo!s +or relatively si$-le #alancing an reconciling o+
accounts"
This a--roach also allo!s the -ossi#ility o+ grou-ing transactions into
categories to -rovie aitional in+or$ation a#out the #reak<u- o+ e3-enses"

2.1.7.3. Ot.er 'ounting issues
Accounting is a co$-le3 area, an there are $any issues that can result in the
+inancial state$ents #eing &uite i++erent to the +igures that !oul #e
e3-ecte +ro$ the unerlying situation"
Accounting stanars also vary +ro$ ti$e to ti$e an +ro$ -lace to -lace"
Book values
Assets are generally recore at their cost -rice, rather than current $arket
value"
*3
Assets are recore in the #alance sheet at their #ook value" This is generally
the cost -rice, less e-reciation"
This $ay #e &uite i++erent to the $arket value"
7e-reciation $ethos use a straight<line +or$ula over a +i3e -erio o+ years,
or one o+ an alternative set o+ $ethos"
&Going concern' "asis
2inancial state$ents are -re-are uner a :going concern; assu$-tion"
This $eans entries are recore on the #asis o+ an o-erational #usiness, not a
static set o+ values"
2or e3a$-le, the li&uiation value o+ $any assets $ay #e $uch lo!er than
the values recore in the #alance sheet"
In the case o+ so$e intangi#le assets, such as a -atent over a ne! -rouction
technology, this $ay #e recore as an asset to the o-erational #usiness,
although it $ay have no value i+ the #usiness cease to o-erate"
Also, assets such as a :+uture inco$e ta3 #ene+it; are recore in the #alance
sheet to re+lect an over-ay$ent or uner-ay$ent o+ ta3, even though these
ite$s !oul not e3ist i+ the #usiness cease to o-erate on the current ate"
Assets relating to +uture events, such as -re-ai interest an :+uture inco$e
ta3 #ene+it; ue to ti$ing i++erences, $ay have @ero value in the event o+ a
li&uiation"
Goodwill
The goo!ill a$ount o+ an ac&uisition has &uestiona#le value, an in so$e
analysis a $ore accurate -icture $ay e$erge #y treating this +igure as a cost
o+ the -urchase in the current year, rather than carrying it +or!ar as an asset
an e3-ensing the a$ount in stages over several years"
Consolidated accounts
/onsoliate accounts are use !hen several #usinesses are co$#ine into a
single entity"
*0
In these cases, the assets an lia#ilities o+ each #usiness are co$#ine into a
single set o+ accounts, to +or$ a -icture o+ the total enter-rise"
()uit* accounts
In the case o+ a -artly<o!ne su#siiary, a -ro<rata allocation o+ the
iniviual assets an lia#ilities o+ the su#siiary $ay #e consoliate into the
#alance sheet o+ the $ain co$-any, to re+lect the total assets an lia#ilities o+
the #usiness"
An other cases, an :e&uity accounting; a--roach $ay #e use"
This involves incluing the share o!nershi- in the su#siiary as a single
asset !ithin the #alance sheet, rather then using a consoliate accounts
a--roach, !here each iniviual asset an lia#ility is inclue" (>> check)
+oreign currenc* translation
2oreign currency transactions $ay occur !hen a #usiness i$-orts or e3-orts
goos, or conucts overseas o-erations"
In these cases, the +oreign currency a$ounts are generally translate into
local currency +or inclusion in the #alance sheet"
This translation $ay use an e3change rate that a--lie on the transaction
ate, an e3change rate on the #alance ate, an average rate through the year
or so$e other +igure"
7e#t $ay also #e raise in +oreign currencies, an overseas assets $ay #e
o!ne"
In these cases, the value o+ the e#ts an assets are translate into local
currencies on each #alance ate"
Moves in e3change rates $ay have ra$atic e++ects on the #alance sheets o+
co$-anies in these cases"
7e-ening on the accounting a--roach use, this $ay also cause large
s!ings in -ro+it an loss ue to changes in e3change rates"
,ntangi"le assets
**
Intangi#le assets, such as -atents, are i++icult to value accurately"
The value o+ an intangi#le asset !ithin the o-erating #usiness $ay also #e
&uite i++erent to the value i+ the asset is sol"
&A"normal' & &(%traordinar*' items
Hner so$e accounting regi$es, ite$s $ay #e classi+ie as orinary ite$s as
-art o+ the #usiness o-erations, or unusual ite$s"
These irregular ite$s $ay #e re+erre to as :a#nor$al; or :e3traorinary;
ite$s"
2or e3a$-le, i+ a #usiness o!ne a #uiling +or $any years an then sol the
#uiling, the -ro+it or loss on the sale !oul not #e -art o+ the nor$al
#usiness activities"
In this case, the ite$ !oul #e liste se-arately as a#nor$al or e3traorinary
ite$"
This !oul lea to aitional entries in the -ro+it<an<loss account, #eing the
-ro+it +ro$ #usiness o-erations, #e+ore a#nor$al ite$s, an net -ro+it a+ter
a#nor$al ite$s"
Signs and negative amounts
Accounting re-resents in+lo!s, out+lo!s an negative a$ounts using several
conventions"
4egative a$ounts are usually -resente in accounts using #rackets, rather
than a $inus sign" 2or e3a$-le, a net loss $ay #e -resente in the +ollo!ing
!ay :4et -ro+it (123);"
5ositive values, !ithout #rackets, re-resent an a$ount o+ the relevant ite$"
2or e3a$-le, a -ositive +igure liste uner inco$e !oul re-resent an in+lo!
to the #usiness, !hile a -ositive +igure liste uner e3-enses !oul re-resent
an out+lo!"
Ite$s are allocate accoring to the ty-e o+ ite$, not accoring to !hether
the iniviual ite$ is an in+lo! or out+lo!"
*)
2or e3a$-le, an in+lo! ue to ti$ing i++erences in ta3 -ay$ents !oul #e
liste uner e3-enses, as ta3 is an e3-ense, regarless o+ the +act that the ite$
!as an in+lo!, not an out+lo!"
In this case, an entry such as :ta3 a9ust$ent ue to ti$ing i++erences (10);
$ay a--ear, inicating that the ite$ is an in+lo!"
This is a ou#le<negative, as a negative e3-ense re-resents a -ositive in+lo!"
Ite$s are also -resente using the ter$s :increase; an :ecrease;"
In these cases, a -ositive a$ount has the sa$e sign as the ite$ escri-tion,
!hile a negative a$ount has the o--osite sign"
2or e3a$-le, :net increase in !orking ca-ital (12); !oul re-resent a
ecrease in !orking ca-ital, as the sign o+ the ite$ reverses the escri-tion"
A result o+ these conventions is that the total o+ a colu$n o+ +igures cannot #e
calculate #y si$-ly aing the +igures together"
The sign o+ each ite$ $ust #e eter$ine iniviually, an either ae to
the total or su#tracte +ro$ the total"
In general, a -ositive +igure +ollo!s the escri-tion o+ the ite$, so that a
-ositive inco$e ite$ is an in+lo!, a -ositive e3-ense is an out+lo!, an a
-ositive :increase; a$ount re-resents an increase in the si@e o+ the ite$"
2igures in #rackets reverse the natural irection o+ the ite$"
*8
2.1.8. Boo66eeping & 'ounting Terms
Account A holing o+ $onetary value" 'alue is
ae to the account or re$ove +ro$
the account using creit an e#it
entries"
/ash #ook A recor o+ cash receive +or each ay
o+ o-eration"
/hart o+ accounts A list o+ the accounts $aintaine !ithin
an accounting syste$"
/reit An entry in an account that recors a
reuction in the value o+ the account"
7e#it An entry in an account that recors an
increase in the value o+ an account"
7e-reciation An e3-ense re+lecting the reuction in
the value o+ an asset over ti$e" This
e3-ense re-resents a reuction in value
an a reuction in net assets, #ut oes
not involve a cash transaction"
7ou#le<entry #ookkee-ing A syste$ uner !hich transactions are
recore as t!o entries, as a e#it
(ae value) to one account, an a
creit (re$ove value) to another
account"
2loat A te$-orary cash #alance $aintaine
to allo! +or i++erences in ti$ing
#et!een cash in+lo! an cash out+lo!"
(eneral leger A set o+ accounts"
Invoice A state$ent that services have #een
-er+or$e or goos elivere, an
re&uesting -ay$ent"
Fournal entry An entry !ithin an account, such as a
creit or e#it entry" (>>check)"
,eger An account, containing creit an e#it
entries (>>check)"
5ost a transaction To create a transaction an a it to an
account"
Raise a transaction To create a transaction an a it to an
account, or issue an invoice"
Raise +uns To #orro! +uns, or to source +uns
+ro$ investors"
Recei-t A recor ackno!leging that -ay$ent
*1
has #een receive"
Reconciliation To co$-are an #alance account values
an transaction lists +ro$ i++erent
in+or$ation syste$s an sources, such
as internal accounting recors an #ank
state$ents" 7i++erences $ay arise ue
to keying errors, lost or $issing ite$s,
so+t!are #ugs, $iss<inter-rete
in+or$ation an ti$ing i++erences in
-osting to i++erent ata sources"
Straight<line e-reciation A $etho o+ calculating e-reciation,
in !hich the asset value is ivie #y
the nu$#er o+ years o+ e3-ecte use+ul
li+e" This $ay -rouces a +igure that
$ay #e use as a constant e-reciation
+igure in each year"
Sus-ense account An account use +or te$-orary holing
o+ ite$s in is-ute or ite$s involving
-rocessing -ro#le$s (>>check)"
Transaction A recor o+ a trans+er o+ +uns" In the
ou#le<entry syste$ this !oul
corres-on to t!o 9ournal entries, a
creit !ithin one account an a e#it
!ithin another account" In the $ore
general sense, a transaction is a recor
o+ an e3change o+ goos, or a trans+er
into or out o+ an account"
Trial #alance An atte$-te #alance #et!een i++erent
accounts, incluing i++erent -rocessing
syste$s an in+or$ation sources"
Accounts o not generally #alance at
the +irst atte$-t, an consiera#le ti$e
an e++ort $ay #e involve in locating
an correcting errors an $issing ite$s"
Drite o++ To re$ove an asset that has #een lost,
an inclue an e3-ense transaction to
recor the loss"
*6
2.1.9. /inanial #tatement Terms
:(oing concern; The technical accounting ter$ +or the +act
that +inancial state$ents are -re-are uner
an assu$-tion o+ an o-erational #usiness"
2or e3a$-le, inco$e that is ue +or recei-t
in a +uture -erio is inclue in the #alance
sheet"
Accounts -aya#le 5ay$ents that are ue #ut have not yet #een
$ae" This is recore as a lia#ility"
Accounts receiva#le 5ay$ents that are ue +ro$ clients or
custo$ers #ut have not yet #een receive"
This is recore as an asset"
A$ortisation An e3-ense that recors a ecline in the
value o+ an intangi#le asset, such as a -atent
!ith a li$ite -erio o+ o-eration"
Asset An ite$ that has $onetary value" This
inclues tangi#le ite$s such a lan,
#uilings an e&ui-$ent" So$e intangi#le
ite$s are also recore as assets, such as the
value o+ a licence or -atent" 7e#ts o!e to
the #usiness are also liste as assets"
Ba an ou#t+ul e#ts A e#t that has -asse the ue ate !ithout
-ay$ent having #een receive" 'arious
creit recovery ste-s $ay #e taken, !ith
so$e e#ts never #eing recovere, an
!ritten o++ as an e3-ense"
Balance sheet A state$ent o+ the assets, lia#ilities, an net
assets o+ the #usiness at a -oint in ti$e"
/a-ital e3-eniture 2uns s-ent on large, long<ter$ ite$s such
as e&ui-$ent, #uilings, an evelo-$ent
o+ ne! +acilities, as o--ose to o-erating
e3-enses !hich are -art o+ the regular
o-eration o+ the #usiness"
/ash +lo! state$ent A state$ent o+ cash -ay$ents receive an
$ae #y the #usiness" The $ay #e grou-e
into o-erating cash +lo! (general inco$e
an e3-enses), invest$ent cash +lo! (sale
an -urchase o+ $a9or assets), an +uning
cash +lo! (e#t an e&uity raise or re-ai)"
/onsoliate accounts Accounts -re-are as a co$#ination o+ the
assets an lia#ilities o+ several relate
#usiness, co$#ine into a single #alance
)0
sheet an -ro+it<an<loss state$ent"
/ontingent lia#ility A lia#ility that $ay or $ay not #e ue,
e-ening on a +uture event" A clai$
against a #usiness that is currently
-rogressing in a court case is a contingent
lia#ility"
/urrent Dithin a one<year -erio" This conce-t
relates to short<ter$ ite$s" A #ank overra+t
is a current lia#ility, as it is technically
re-aya#le on call, even though it $ay have a
long<ter$ #alance as -art o+ ongoing
o-erations"
7e#t 2uns #orro!e +ro$ #anks or investors"
7e-reciation An e3-ense that recors a ecline in net
assets over the -erio, ue to a reuction in
the value o+ an asset such as e&ui-$ent"
%BIT %arnings Be+ore Interest an Ta3" This is
the o-erating -ro+it o+ the #usiness, #e+ore
-ay$ent o+ +uning costs relating to
interest"
%BIT7A %arnings Be+ore Interest, Ta3, 7e-reciation
an A$ortisation" This is the net cash +lo!
o+ the #usiness, an is the o-erating -ro+it
#e+ore eucting e-reciation an interest
costs"
%&uity A!nershi- o+ assets" The assets o+ a
#usiness are o!ne #y the shareholers or
o!ners o+ the #usiness" Also use in the
conte3t o+ raising +uns +ro$ investors +or
use !ithin a #usiness"
%&uity accounts Accounts !hich recor the invest$ent in
another #usiness as an invest$ent asset on
the #alance sheet, as o--ose to
consoliate accounts !hich inclue each
iniviual asset an lia#ility !ithin the
consoliate #alance sheet" (>>check)
%3-ense 5ay$ents $ae #y the #usiness in the
nor$al course o+ o-erations" This oes not
inclue -ay$ents $ae +or ca-ital -ur-oses,
such as -urchases o+ e&ui-$ent an
ivien -ay$ents"
2uture inco$e ta3
#ene+it
An asset ue to ti$ing i++erences #et!een
accounting entries an ta3 calculations,
!hich !oul reuce +uture ta3 -ay$ents"
)1
(oo!ill The e3cess -rice -ai !hen -urchasing a
#usiness a#ove the value o+ the #usinessCs
net assets" This $ay re-resent the value o+
the regular o-erations o+ the #usiness as a
going concern, or it $ay #e a cost -ai +or
strategic reasons such as entry into a
$arket" (oo!ill is recore as an
intangi#le asset on the #alance sheet, an
a$ortise over a -erio o+ ti$e"
Inco$e 5ay$ents receive #y the #usiness" This
oes not inclue -ay$ents receive ue to a
ca-ital trans+er, such as the sale o+ a
-ro-erty"
Intangi#le asset An asset !ith $onetary value #ut !ithout
-hysical +or$" This inclues -atents, trae
$arks, $eia $astheas an goo!ill on
ac&uisition"
,ia#ility An a$ount o!e #y the #usiness" This
inclues e#ts, an a$ounts ue +or other
reasons such as settle$ent o+ court cases
an +uns set asie +or s-eci+ic -ur-oses"
,oss A reuction in the net assets o+ a #usiness
ue to o-erations (rather than ue to ca-ital
events such as ca-ital istri#ution to
shareholers)
Masthea The na$e o+ a ne!s-a-er" A $asthea can
have consiera#le value, an is recore in
the accounts as an intangi#le asset"
4et assets The e3cess value o+ assets a#ove lia#ilities"
This is the value o+ the #usiness as a static
holing, an in conce-t this !oul #e the
a$ount re$aining i+ all assets !ere sol an
all e#ts re-ai"
4et inco$e 4et -ro+it
4et -ro+it The e3cess o+ inco$e a#ove e3-ense ite$s"
This inclues non<cash e3-enses such as
e-reciation, !hich recors a reuction in
value ue to the ecline in the value o+
e&ui-$ent" 4et -ro+it is the change in
e&uity +uns ue to the o-eration o+ the
#usiness" (>> check -Jl treat$ent o+ asset
revaluations)
4on<current Relating to long<ter$ ite$s, s-eci+ically
ite$s that !oul nor$ally trae over
)2
-erios that !ere longer than one year"
45AT 4et 5ro+it A+ter Ta3" This is the net -ro+it o+
the #usiness"
A-erating cash +lo! /ash +lo! ue to #usiness o-erations, the
e3cess o+ inco$e a#ove o-erating e3-enses"
This oes not inclue cash trans+ers o+ a
ca-ital nature such as raising ne! e#t,
re-aying e#ts, ivien -ay$ents etc"
5atent A license issue #y a govern$ent authority
giving the evelo-er o+ an invention the
e3clusive right to use the invention +or a
-erio o+ ti$e" 2or e3a$-le, a -atent
grante to an inventor o+ a -rouct !oul
allo! the inventor to $anu+acture or licence
the -rouct +or a -erio o+, +or e3a$-le, 20
years, !ithout others co-ying an using the
invention" At the en o+ the -atent ter$,
these rights e3-ire an the invention
#eco$es -art o+ the -u#lic o$ain (>>
check -atent ter$)"
5ro+it An increase in the assets o+ the #usiness ue
to o-erations (rather than ca-ital trans+ers
such as raising aitional +uns +ro$
investors)"
5ro+it<an<loss account A recor o+ the transactions that occurre
uring a -erio, incluing inco$e,
e3-enses, an non<cash changes in value
such as e-reciation"
5ro<+or$a +inancial
state$ents
State$ents -re-are to re-resent a -ossi#le
situation, rather than an historical event" 2or
e3a$-le, a -ros-ectus to +loat a #usiness, a
9oint venture -ro-osal, or accounts $oi+ie
+or analysis -ur-oses $ay inclue -ro<
+or$a accounts listing the +inancial
state$ents as they !oul a--ear a+ter the
event"
5rovision A lia#ility that recors an a$ount set asie
+or a s-eci+ic -ur-ose" 2or e3a$-le, a
-rovision is generally inclue +or #a
e#ts, !here a certain -ercentage o+
-ay$ents ue are never recovere"
Revenue Inco$e receive +ro$ clients an
custo$ers"
Sales 5ay$ents receive +or the sale o+ goos to
)3
custo$ers, or elivery o+ services to clients"
ShareholerCs +uns,
ShareholerCs e&uity
The net assets o+ the #usiness"
Tangi#le asset An asset !ith -hysical +or$, such as lan,
#uilings an e&ui-$ent"
Trae creitors A$ounts o!e to su--liers"
Trae e#tors A$ounts ue +ro$ custo$ers"
Trae $ark A #ran na$e, #usiness logo or other ite$
that re-resents a #ran" I+ a license trae
$ark is co-ie or i$-ersonate #y another
-arty, the o!ner o+ the trae $ark can take
legal action to recover the lost value"
)0
.. 'a%
2.2.1. T.e nature of la5
A la! is a escri-tion o+ a cause<an<e++ect"
The la! o+ gravity, +or e3a$-le, is a $athe$atical relation escri#ing the
+orces #et!een o#9ects ue to gravity"
The la! o+ su--ly an e$an escri#es the e++ect that -rices !ill rise !hen
e$an is high an su--ly is lo!, an +all !hen e$an is lo! an su--ly is
high"
The la!s !ithin a society escri#e an unerstaning or !ritten rule, that a
certain action !ill #e taken !hen a situation arises or a s-eci+ic action is
-er+or$e"
Murer, +or e3a$-le, is co$$only +or#ien !ithin societies"
The la! against $urer escri#es a rule that, shoul a $urer #e -er+or$e,
action !ill #e taken"
This action $ay result in arrest, trial an i$-rison$ent, or so$e other
-enalty"
2.2.2. 8a5 in various situations
Dithin a !ilerness situation containing se-arate iniviuals, la! oes not
e3ist"
Actions are taken, an res-onses co$e +orth"
Ani$als hunt +oo using s-ee an stealth"
=unte ani$als esca-e -reators using s-ee, e+ences, ca$ou+lage, an
res-oning !ith attack"
In nature, an in !ilerness situations, -enalties are not a--lie to other
creatures"
)*
%ach creature a--roaches other creatures uner certain circu$stances, an
$ay #y $et !ith an attack, +light or other res-onse"
Dithin social grou-s o+ #oth -eo-le an ani$als, several situations $ay
e3ist"
In so$e cases, iniviuals are !iely is-erse, an there is no authority or
control"
In this situation, la!s $ay #e escri#e as the co$$on res-onse to -articular
events"
2or e3a$-le, an atte$-t to steal ite$s +ro$ an iniviual or grou- $ay result
in an aggressive res-onse"
Although this !oul not #e a la! in the traitional sense, these res-onses
!oul escri#e the co$$only e3isting cause an e++ect o+ actions"
These situations coul #e escri#e as res-onses, rather than la!s, ue to the
+act that no -erson !oul #e in a -osition to i$-ose a -enalty on another
-erson #y +orce"
,a!s generally e3ist in a social grou- that re$ains in close contract"
The la! is eter$ine #y the iniviual or grou- that is in control o+ activity
!ithin the entire grou-"
Dithin tri#al grou-s, this $ay #e a o$inant leaer, !ho hols authority an
has the a#ility to cause actions to #e taken
Alternatively, a council o+ elers $ay -ass 9uge$ent an orer -enalties to
#e a--lie"
2.2.3. T.e .istor$ of la5
The source o+ $oern la! can #e trace #ack several thousan years"
In !estern societies, the 9uge$ents o+ Solo$on an the la!s o+ Moses lai
o!n $any o+ the -rinci-les that $oern la! is #ase on"
In Isla$ic countries, the Koran is a $a9or source o+ la!"
))
In so$e societies, the la!s o+ the Koran are a--lie rigorously, !hile in other
societies a secular, non<religious legal syste$ a--lies"
(>> la! in various culturesJcountries)
2.2.4. 8a5 an( ,eligion
Moern la! is close tie !ith religion"
The -rinci-les o+ the la! in $any societies are #ase on religious !ritings
an -rinci-les"
In so$e countries, the la! is eter$ine irectly +ro$ religious !ritings, an
9uge$ents are $ae in religious courts #y -riests or other religious
authorities !ho inter-ret an a--ly the la!s"
In other societies, religious courts an secular courts o-erate concurrently"
The religious court $ay eal !ith issues regaring religious la!, !hile the
secular court $ay eal !ith co$$ercial is-utes an other issues"
In other societies a secular legal syste$ a--lies, although in these cases the
-rinci-les a--lie are o+ten +oune in religious history"
2.2.5. 8egal #$stems
,egal situations arise in t!o #asic categories"
Criminal & civil law
/ri$inal la! a--lies to actions taken against an iniviual, in res-onse to an
action #eing -er+or$e"
Murer an the+t are co$$only +or#ien, an action is taken against
iniviuals !ho -er+or$ these acts"
In the case o+ cri$inal la!, action is taken #y society in general, also re+erre
to as the state"
/ivil la! a--lies to is-utes #et!een t!o iniviuals"
)8
2or e3a$-le, a -rouct $ay #e elivere to a custo$er"
The custo$er $ay re+use -ay$ent, clai$ing that the -rouct !as not the
-rouct that !as re&ueste"
This is-ute !oul then #e taken to a court, !hich !oul -ass 9uge$ent on
the situation, an orer -ay$ent +ro$ one -arty to the other as co$-ensation
+or any loss incurre"
-rial s*stems
Several a--roaches $ay #e use to conucting trails, e-ening on the
-articular legal syste$"
The aversarial syste$ vie!s a court case as a contest #et!een the t!o
-arties"
The t!o -arties sit sie<#y sie in the court roo$"
The 9uge controls the trial -rocess an rules on technical issues, !hile the
t!o -arties -resent their cases to the 9ury"
The 9ury then -asses 9uge$ent"
In so$e situations, only a 9uge or -anel o+ 9uges hears a case, rather than a
9ury"
The aversarial syste$ is use in the Hnite States"
The in&uisitional syste$ -laces the accuse uner e3a$ination"
The accuse sits in the ock, uner e3a$ination #y the 9uge an 9ury"
This in&uisitional syste$ is use in so$e Asian countries"
%nglish la!, on !hich Australian la! is #ase, uses a syste$ that contains
ele$ents o+ #oth an in&uisitional an an aversarial syste$"
In the %nglish la! traition, the accuse sits in the ock, an is e++ectively
-lace uner e3a$ination in a si$ilar !ay to the in&uisitional syste$"
=o!ever, unlike the in&uisitional syste$, the accuse is not &uestione
irectly #y a 9uge or 9ury"
)1
2.2.!. T.e la5 in pratie
7is-utes in co$$ercial transactions are co$$on, an court cases involving
co$$ercial is-utes are a co$$on event in #usiness activity"
In -ractice, ho!ever, the la! o+ten has li$ite use in a situation o+ loss"
/ourt cases can take $onths or years, an involve large su$s o+ $oney an
ti$e"
I+ the case is lost, a large -ay$ent to the other -arty $ay result"
Dinning the case $ay involve a re+un o+ the +uns that !ere lost"
=o!ever, this $ay not co$-ensate +or the ti$e s-ent, the elay in recovering
the +uns, an other costs involve"
In the case o+ s$all transactions, the use o+ legal action $ay si$-ly #e
i$-ractical"
In $any cases a #usinessCs involve$ent !ith the legal syste$ $ay co$e
a#out through #eing a e+enant to legal action initiate #y another -arty"

In -ractice, the -erson !ith -hysical -ossession o+ an ite$ $ay hol a great
avantage"
2or another -arty to gain -ossession o+ an ite$ through the legal syste$ $ay
involve a great eal o+ ti$e, cost, an an uncertain outco$e"
2or e3a$-le, goos $ay #e elivere, an then -ay$ent $ay #e re+use"
In this case, the custo$er has -hysical -ossession o+ #oth the goos an the
+uns"
The custo$er then has the +ull use o+ the goos an the +uns +or the uration
o+ any court case, !hich $ay take $onths or even years"
The su--lier, in contrast, has neither the goos nor the +uns, an $ust -ay
the legal costs until the case is co$-lete"
In the o--osite case, -ay$ent $ay #e $ae in avance, ho!ever the goos
$ay not the elivere"
)6
In this case, the su--lier has -hysical -ossession an #ene+it o+ #oth the
goos an the +uns"
5ro#le$s such as these can #e reuce !hen traing takes -lace on the #asis
o+ -hysical -ossession an e3change, rather than legal rights an o#ligations"
In the case o+ s$all transactions, this $ay involve e3changing the -ay$ent
an the ite$ uring the sa$e e3change"
In the case o+ larger transactions, +uns can #e hel in a trusteeCs na$e in an
escro! account, to ena#le the e3change to #e $ae !ithout the risk o+ the
#usiness loosing #oth the +uns an the ite$"
In $any cases, the legal syste$ $ay #e a istant #ack<u- to e3change #ase
on -hysical -ossession"
2.2.7. T.e (evelopment of 'ustralian la5
Australian la! is #ase on the history o+ %nglish la!, !hich traces #ack to
the (>> check century) century"
Ariginally, the ter$ :court;, in the sense :court o+ la!;, arose +ro$ the court
o+ the king"
This !as the -lace an situation in !hich the ruler at the ti$e gave
instructions an orers to #e -er+or$e"
7is-utes #et!een iniviuals !ere #rought #e+ore the king, !ho -asse
9uge$ent an orere action to #e taken"
Aver ti$e these iniviual 9uge$ents evelo-e into a set o+ -rinci-les an
la!s"
As the -o-ulation e3-ane, it no longer #eca$e -ractical to #ring every
iniviual is-ute #e+ore the ruling $onarch"
,ocal courts !ere esta#lishe an 9uge$ents $ae #y a--ointe 9uges or
local lors or #arons (>>check ti$ing o+ 9uges vs" rulers)
Common law
These 9ug$ents evelo-e into a set o+ -rinci-les kno!n as co$$on la!"
80
These la!s are not !ritten e3-licitly, #ut are the general -rinci-les that have
arisen +ro$ a range o+ i++erent cases an 9uge$ents"
The history o+ %nglish la! also inclues a -erio in !hich t!o se-arate court
syste$s !ere in o-eration"
These gave rise to the co$$on la!, an the la! o+ e&uity"
A single court syste$ has o-erate in $oern ti$es, an the co$$on la! o+
toay ra!s on the 9uge$ents o+ all -revious cases"
Precedent
The legal syste$ o-erates on the -rinci-le o+ -receent"
This states that the -rinci-les e$erging +ro$ -revious cases an 9uge$ents
are #ining, an +or$ la!s that $ust #e a--lie !hen ne! cases are hear"
Statutor* law
Statutory la! is la! that is !ritten as e3-licit actions in res-onse to s-eci+ic
events"
Ariginally !ritten la! inclue state$ents an la!s eclare #y the king"
The evelo-$ent o+ -atents +or inventions traces #ack to eclarations $ae
#y (>> check ate)"
Dithin e$ocratic societies, the la! is !ritten #y -arlia$ent"
Bills are -resente to the houses o+ -arlia$ent, vote on, an #eco$e la! i+
the vote is +avoura#le"
Statutory la! overries -receent !ithin the co$$on la! +ro$ -revious
court cases, in situations in !hich a statutory la! $ay alter or reverse an
e3isting co$$on la! -rinci-le"
Structure of the legal s*stem
The legal syste$ o-erates ine-enently o+ the -olitical syste$"
81
(>> a--oint$ent o+ 9uges, electionJno$ination etc)
,a!s -asse #y -arlia$ent are a--lie #y 9uges in hearing court cases"
In situations !ere !ritten la!s are not availa#le, -receent an the co$$on
la! is use"
/ri$inal la! a--lies to an action #y the state against an iniviual"
This a--lies to a range o+ actions that are eclare to #e cri$inal o++ences"
Dithin a cri$inal la! case, guilt $ust #e esta#lishe #eyon reasona#le
ou#t"
/ivil la! a--lies to is-utes #et!een t!o -arties"
Dithin a civil la! case, the #uren o+ -roo+ is lo!er, an the ecision is
$ae on the #alance o+ evience"

2.2.8. 8egal +onepts
The la! recognises a nu$#er o+ i++erent conce-ts"
These inclue -ro-erty rights, contract, in9ury, e#t, agency, an -ro-erty
hel on trust"
2.2.8.1. 3ropert$ rig.ts
Most non<co$$unist countries recognise the conce-t o+ -ro-erty rights"
This $eans that a -erson can o!n -ro-erty, an !ill then -osses certain
rights !hich are en+orce #y the la!"
The legal use o+ the !or :-ro-erty; a--lies to anything that is o!ne"
This is not restricte to lan an #uilings"
2or e3a$-le, a -iece o+ e&ui-$ent that is o!ne #y a #usiness is consiere
an ite$ o+ -ro-erty using the +inancial an legal use o+ the ter$"
82
5ro-erty inclues lan an #uilings, e&ui-$ent an other -hysical o#9ects,
rights to receive -ay$ent such as $oney ue +ro$ #orro!ers, intangi#le
-ro-erty such as -atents an licenses, an cash"
In a !ilerness situation, +or e3a$-le, -ro-erty a--lies to lan an ite$s that
can #e -hysically e+ene against e3ternal actions"
In a society that recognises -ro-erty rights, -hysical e+ence o+ an area is not
necessary"
A #uiling can #e o!ne on the o--osite sie o+ the !orl, an action !ill #e
taken #y the society i+ the #uiling is a$age or #roken into"
-rading
5ro-erty can #e trae +or other -ro-erty"
In each case, o!nershi- o+ the -ro-erty -asses to the receiving -arty"
In $ost transactions, one ite$ is a su$ o+ $oney, !hile the other ite$ is a
service or an ite$ o+ -ro-erty"
Lending
5ro-erty can also #e loane to other -arties"
In these cases, various situations a--ly"
The o!ner o+ the -ro-erty retains o!nershi- o+ the -ro-erty, ho!ever the
#orro!er also has certain legal rights"
2or e3a$-le, a tenant renting -re$ises has the legal right to +ull use o+ the
-re$ises, an the o!ner cannot enter !ithout giving -ro-er notice an
+ollo!ing certain ste-s"
5ro-erty that is loane $ay #e ue +or return on re&uest, a+ter a +i3e -erio
o+ ti$e, or uner other conitions"
,ease or rent -ay$ents $ay #e $ae in e3change +or the use o+ the -ro-erty
+or a -erio o+ ti$e"
Gifts
83
5ro-erty can #e given as a gi+t, in !hich case o!nershi- o+ the -ro-erty
-asses to the reci-ient"
A gi+t is not a contract, as this is a one<sie transaction an -ay$ent is not
involve"
=o!ever, once the gi+t occurs, the o!nershi- changes into the na$e o+ the
receiving -arty"
This can #e +or$alise in a ee o+ gi+t, !hich is si$ilar to a trust ee
regaring -ro-erty hel on trust, an eclares in !riting that the event has
occurre"
(i+ting is use in co$$ercial situations to trans+er -ro-erty into alternative
vehicles"
2or e3a$-le, a 9oint venture $ay #e esta#lishe using a trust arrange$ent,
!ith the assets use to +un the venture #eing gi+te into the trust at the
co$$ence$ent o+ the enter-rise"
2.2.8.2. +ontrat
A contract is an agree$ent #et!een t!o -arties"
This agree$ent generally involves the trans+er o+ goos or services, an $ust
inclue co$-ensation o+ so$e kin in orer to #e a legally en+orcea#le
contract"
2.2.8.2.1. ,e9uirements
A contract re&uires the +ollo!ing ste-s to #e legally en+orcea#le
1" /a-acity
2" An A++er
3" An Acce-tance
0" /onsieration
*" Intention to +or$ legal relations
2.2.8.2.1.1. +apait$

80
/a-acity re&uires that the -arty agreeing to the contract is a#le to o so"
In general any iniviual or co$-any is assu$e to have ca-acity"
=o!ever, a contract $ay not #e #ining in cases o+ $ental inca-acity,
runkenness, contracts !ith $inors, or in cases o+ uress !here inti$iation
is use"
2.2.8.2.1.2. Offer & 'eptane
An o++er is a state$ent that an o++er to conuct a transaction is #eing $ae,
an clearly s-eci+ying the ter$s o+ the o++er"
Acce-tance is a clear state$ent that the o++er is acce-te"
Dhen acce-tance is given, the contract co$es into e3istence at that -oint in
ti$e"
A countero++er is consiere to #e a se-arate o++er, $ae to!ars the other
-arty"
A iscussion or negotiation has no legal e++ect"
A contract cannot #e +or$e until a clear state$ent is $ae that an o++er is
#eing -ut +or!ar, the ter$s o+ the o++er are s-eci+ie, an a clear state$ent
o+ acce-tance is given"
er"al contracts
There is no re&uire$ent in general +or a contract to #e in !riting or to #e
signe"
A ver#al contract is e&ually #ining, as long as a clear o++er an acce-tance
has occurre"
In so$e -articular cases, such as the sale o+ lan (>> check), a contract $ust
#e !ritten to #e vali"
In general, ver#al contracts are legally #ining, as long as a clear o++er an a
clear acce-tance have #een given"
8*
2or e3a$-le, an orer o+ a -rouct through a tele-hone call $ay +or$ a
contract #et!een the custo$er an the #usiness, even though no !ritten
ocu$entation is involve, an no ocu$ents are signe"
=o!ever, ver#al agree$ents are very i++icult to -rove"
In -ractice, a !ritten an signe ocu$ent is necessary #e+ore the #usiness
coul consier that a contract !as in -lace"
,mplied acceptance
Acce-tance can also #e i$-lie #y an action, rather than #eing an e3-licit
state$ent"
2or e3a$-le, i+ an o++er !as $ae +or -ay$ent +or a #uiling activity, an
the #uiling activity !as starte, then this $ay #e inter-rete #y a court as an
i$-lie acce-tance o+ the o++er"
This !oul +or$ a #ining contract, even through a state$ent o+ acce-tance
$ay not have #een $ae"
Discussions and &invitations to treat'
Avertising an general iscussions are kno!n as an :invitation to treat;, an
are not consiere an o++er"
.ithdrawing offers
An o++er $ay #e !ithra!n at any ti$e #e+ore acce-tance is given"
=o!ever, once acce-tance has #een clearly given, neither -arty can !ithra!
+ro$ the contract !ithout the consent o+ the other -arty"
Ance acce-tance is given, #oth -arties are #oun #y the contract, an cannot
!ithra! +ro$ the contract !ithout the other -artyCs consent"
(%changes in practice
In the case o+ s$aller e3changes, ver#al agree$ent $ay #e taken to suggest
that the other -arty $ay a--ear on the settle$ent ay !ith the ite$ or the
+uns"
8)
I+ the other -arty a--ears, then an e3change is $ae, other!ise the
arrange$ent la-ses"
In the strict legal sense, a contract is create !hen the other -arty gives
ver#al agree$ent to the ter$s"
In the -ractical case o+ $any transactions, ho!ever, -hysical e3change o+ the
ite$s is the only action that causes a change in o!nershi- to occur"
2.2.8.2.1.3. +onsi(eration
/onsieration is anything o+ value that is -rovie in e3change +or the ite$"
This $ay inclue a cash -ay$ent, another ite$ in return, or a service to #e
-er+or$e"
An agree$ent to su--ly a gi+t is not a contract, an a contract is not vali
unless so$e consieration is -rovie in return +or the ite$"
In so$e cases action can #e taken i+ -ro$ises are $ae, the -ro$ises are not
ke-t, an a$age is su++ere as a result o+ relying on the -ro$ises"
=o!ever, this action is not taken uner contract la!"
This situation is kno!n as -ro$issory esto--el"
(>> check etails)
5ro$issory esto--el a--ears rarely in co$$ercial la!"
In general, the re&uire$ents o+ contract la! s-eci+y the conitions that are
necessary to +or$ a legally #ining agree$ent #et!een t!o -arties"
A court oes not asses the value o+ the consieration"
There is no re&uire$ent that the consieration have si$ilar value to the ite$
accoring to any -articular $easure"
A sale o+ a large -ro-erty +or one ollar !oul #e a legally en+orcea#le
contract, assu$ing that all other re&uire$ents !ere in -lace"
A no$inal +ee is so$eti$es kno!n as a :-e--ercorn rental;, in re+erence to a
+a$ous case in %nglish la! in (>>check ate)"
88
In this case, a -ro-erty !as lease +or a rent o+ one -e--ercorn -er year"
The court hel that this !as a vali contract, as the ecision to enter the
contract !as a ecision to #e $ae #y the -arties, not a ecision to #e $ae
#y the court"
4o$inal +ees such as a one ollar license +ee are so$eti$es use in cases
!here the intention is to allo! usage !ithout charge"
=o!ever, !ithout the no$inal +ee, contract la! !oul not #e triggere an
!oul not a--ly, as contract la! oes not a--ly to gi+ts or situations in !hich
consieration is not involve"
2.2.8.2.1.4. 4ntention to reate legal arrangements
A contract is only en+orcea#le !hen there is a clear intention to create legal
relations"
In other ter$s, the -arties $ust inten to enter a #ining agree$ent"
Agree$ents in o$estic an -ersonal situations are not legally en+orcea#le
contracts"
2.2.8.2.1.5. Ot.er ontrat issues
A range o+ other $inor issues a--ly"
/istake
2or e3a$-le, a contract to co$$it a cri$e is not a legally #ining contract,
!hile a contract that contains a $istake, such as a ty-ing error in an account
nu$#er, is not hel to the literal te3t"
In this conte3t, ho!ever, :$istake; oes not inclue regret or -oor
9uge$ent, #ut a--lies to situations !here a clear $isunerstaning has
occurre"
81
2or e3a$-le, i+ an incorrect ite$ !as e$onstrate to a -erson an they
signe a contract o+ -urchase, this contract $ay not #e #ining, as the ite$
sho!n !as not the ite$ that they #elieve that they !ere -urchasing"
The ter$ :$istake; is a--lie e3tre$ely strictly, an this situation is usually
only a--lie to cases !here a clear error !as $ae, such as a ty-ing $istake
or is-laying the !rong ite$"
The legal ter$ in this case is that there $ust #e a :$eeting o+ $ins; in orer
+or a contract to #e +or$e"
In other !ors, #oth -arties $ust have the sa$e clear $ental unerstaning
o+ the agree$ent that they are $aking"
=o!ever, the #asic -rinci-le o+ contract la! is that the la! !ill en+orce the
right o+ a -arty to rely on state$ents an agree$ents $ae #y the other -arty"
(reat care an consieration shoul #e given #e+ore signing any ocu$ent or
agree$ent"
Hner contract la!, the other -arty is entitle to -rocee !ith the ter$s o+ the
contract as soon as agree$ent is given"
I+ a -arty signs a contract an then +ails to -er+or$ the actions that are liste
in the contract, the other -arty can then sue the$ to recover a loss that they
have incurre"
In so$e cases, issues $ay arise i+ an agent, irector or other -arty acts in
contraiction to instructions, or outsie the li$its o+ the authority that !as
grante, in signing a contract"
In general, a -arty to a contract is entitle to assu$e that the other -arty has
ca-acity an authority to -er+or$ the act that they -er+or$ #y signing a
contract"
These situations $ay #e co$-le3, #ut one scenario !oul #e that the contract
re$ains #ining, !hile the -erson !ho a--ointe the agent then sues the
agent +or #reach o+ trust to recover their loss"
+ulfilment of a contract
A contract is e3tinguishe !hen the actions s-eci+ie in the contract are
-er+or$e"
86
2or e3a$-le, an ite$ $ay #e o++ere +or sale at a certain -rice"
A #uyer $ay then acce-t the o++er"
At this -oint, a contract a--ears, an the #uyer is legally o#ligate to eliver
-ay$ent, an the seller is legally o#ligate to eliver the ite$"
Dhen the ite$ an the -ay$ent are e3change, the actions !ithin the
agree$ent have #een +ul+ille, an the contract issolves"
In -ractical situations, such as -urchasing an ite$ !ithin a sho-, these events
occur legally, although co$$on -ractice involves selecting an ite$ an
$aking -ay$ent, rather that stating an o++er an an acce-tance"
The -ur-ose o+ a contract is to ena#le a -arty to recover a loss that is cause
#y the other -arty not +ul+illing their re&uire actions uner the contract"
/o$$only, a contract a--lies to su--lying a -rouct or service in e3change
+or a -ay$ent"
I+ a -rouct is su--lie an -ay$ent is not $ae, then this is a #reach o+ the
contract #y the custo$er"
The su--lier coul then initiate a legal action against the custo$er"
In a clear case, the court !oul then recognise the contract an orer that the
custo$er $ake the re&uire -ay$ent"
In co$$on situations such as #uying an selling, no !ritten ocu$entation
is neee to esta#lish that a contract is in -lace, an that -ay$ent shoul #e
$ae or that goos shoul #e elivere"
A -arty that re+uses to co$-ly !ith a court orer $ay #e su#9ect to +ines an
ulti$ately i$-rison$ent"
A contract can also #e issolve #y #oth -arties agreeing to !alk a!ay +ro$
the agree$ent"
/isrepresentation and #egligent /isstatement
In general, a contract can #e assu$e to #e legally #ining, unless so$e
-articular circu$stances are in -lace"
10
:Misre-resentation; a--lies !hen the other -arty $akes +alse state$ents in
iscussions #e+ore the contract !as agree"
This $ay inclue state$ents o+ +act that !ere not accurate"
Also, in so$e cases, $isre-resentation can occur #y o$ission"
This $ay occur !hen the other -arty clearly has $ae an assu$-tion
regaring a &uestion o+ +act that is incorrect, an the other -arty re$ains
silent an +ails to correct the $isunerstaning"
2or e3a$-le, in the sale o+ a restaurant, the #uyer $ay co$$ent on the large
nu$#er o+ e3ternal ta#les availa#le +or custo$ers"
=o!ever, i+ so$e o+ the ta#les !ere associate !ith the a9oining restaurant,
rather than !ith the restaurant +or sale, an the seller re$aine silent an i
not correct this clearly $istaken #elie+, then this $ay #e a $isre-resentation
#y o$ission"
In general a seller or other -arty to a contract oes not +ace any re&uire$ents
to $ake state$ents or su--ly in+or$ation"
The other -arty $ay ask &uestions, an the seller $ay -rovie ans!ers, or
ecline to ans!er the &uestion"
The #uyer $ust then $ake their ecision #ase on the in+or$ation availa#le
to the$"
Misre-resentation a--lies !hen a +alse state$ent is $ae, on in e3ce-tional
circu$stances, !here a state$ent is not $ae to correct a clearly $istaken
assu$-tion"
In cases o+ $isre-resentation, a contract $ay not #e #ining"
:4egligent $isstate$ent; occurs !hen a -arty recklessly $akes state$ents
!ithout su++icient #asis +or kno!ing !hether they are true or not"
This $ay not #e #ase on eli#erate +alse state$ents"
In other cases, the in+or$ation $ay #e correct or incorrect, !ithout the -arty
having a su++icient #asis to -ut +or!ar the state$ents as #eing accurate"
In this case, i+ the state$ents later turn out to #e incorrect, an the other -arty
su++ers a loss ue to this, then the contract $ay not #e #ining, ue to the
negligent state$ents"
11
0nsolicited goods and services
Hnsolicite goos an services involve elivering goos or -er+or$ing
services that the custo$er has not re&ueste"
In this situation, the custo$er oes not have an o#ligation to -ay +or the
-rouct or service"
2or e3a$-le, an ite$ $ay #e sent to a custo$erCs aress !ithout the
custo$er re&uesting the ite$"
An invoice $ay later #e sent re&uesting -ay$ent"
In this situation, no contract is in -lace, as an o++er !as not given an
acce-tance !as not su--lie"
The custo$er !oul #e uner no o#ligation to -ay +or the -rouct, or take
ste-s to return the -rouct to the sener"
=o!ever, o!nershi- o+ the -ro-erty $ay re$ain !ith the sener, an the
custo$er $ay not have the right to retain the ite$ i+ the sener atte$-te to
retrieve it"
I+ a -erio o+ ti$e ha -asse, ho!ever, o!nershi- o+ the ite$ $ay #e sai to
have -asse into the hans o+ the custo$er"
This $ay -articularly a--ly i+ no co$$unication !as involve +or an
e3tene -erio o+ ti$e an the custo$er -ut the ite$ to so$e -ractical use"
=o!ever, this is an e3a$-le o+ a situation !here the la! oes not have clear
o-eration, an the iniviual circu$stances o+ each case $ay #e consiere"
A $ore co$-le3 situation arises !hen a service has #een -er+or$e or a
-rouct has #een create, an the situation cannot #e reverse"
In a si$-le e3a$-le, a -erson $ay $o! the la!n o+ a custo$er !ithout the
custo$erCs kno!lege, an then e$an -ay$ent"
The service !oul alreay have #een -er+or$e, an coul not #e unone"
In another e3a$-le, a large ite$ $ay #e orere #y a custo$er, an
aitional +eatures $ay #e ae !ithout the custo$er having re&ueste
the$"
12
In #oth these cases, the custo$er has an o#ligation -ay only +or the -arts o+
the -rouct, or any service, that they actually re&ueste"
A hair cut is another e3a$-le o+ a service"
A hairresser !oul not nor$ally cut the hair o+ a client !ithout +irst
con+ir$ing that the style o+ cut !as the style that the client actually !ante"
In so$e cases, the custo$er $ay also #e a#le to take action against the
su--lier, +or -er+or$ing a service that the custo$er i not !ant, an that
cannot #e reverse"
This $ay involve legal action uner tres-ass, !hich relates to accessing or
altering -ro-erty o+ a -erson !ithout their consent"
In so$e circu$stances, -roviing unsolicite -roucts an services is
-rohi#ite uner the co$$ercial la!, an $ay attract -enalties"
In so$e cases, unsolicite services are little $ore than a +or$ o+ e3tortion"
This involves -er+or$ing a service !ithout the clientCs kno!lege or
consent, an then e$aning -ay$ent, in the +ull kno!lege that $any
-otential clients !oul say no i+ o++ere the service in avance"
In other cases, an assu$-tion $ay #e $ae that a custo$er $ay !ant a
-articular -rouct or service, an the -rouct $ay #e create or the service
-er+or$e !ithout the custo$erCs kno!lege or consent"

This shoul not occur +or t!o reasons"
2irst, the assu$-tion $ay #e !rong, an the custo$er $ay not actually !ant
the goos"
More i$-ortantly, the ecision to select a service or ite$ is a ecision to #e
$ae #y the custo$er, not #y anyone else, an the #usiness or any other
-arty oes not have a right to -rocee !ithout the kno!lege o+ the custo$er
an consent #eing given"
In general a #usiness shoul not eliver goos or -er+or$ a service unless a
clear re&uest has #een $ae #y the custo$er or client"
13
2.2.8.3. 3.$sial possession
The la! oes not recognise -hysical -ossession o+ an ite$ as #eing
o!nershi- o+ the ite$"
Hner the la!, -hysical -ossession an o!nershi- are t!o se-arate conce-ts"
2or e3a$-le, an ite$ o+ e&ui-$ent $ay accientally #e shi--e to the !rong
aress"
In this case, the receiver !oul have no legal #asis to clai$ o!nershi- o+ the
ite$, an o!nershi- o+ the ite$ !oul re$ain !ith the sener"
In this situation, a court !oul nor$ally orer that the receiver han the ite$
over to the sener i+ they atte$-te to retrieve it"
=o!ever, there is a legal -rinci-le kno!n as (>> check na$e), that suggests
that o!nershi- o+ an ite$ $ay -ass into the hans o+ a -erson having
-hysical -ossession, !hen a long -erio o+ ti$e has -asse an clear legal
arrange$ents are not in -lace"
2or e3a$-le, the +ence line #et!een t!o -ro-erties $ay #e incorrectly
$arke"
The -ro-erties on each sie o+ the +ence $ay #e #ought an sol $any ti$es,
!ith the value o+ each -ro-erty assu$ing that the +ence $arker !as correct"
I+ the error !as iscovere at a +uture ate, a court $ay orer that the
e3isting +ence -osition #eco$es the e++ective o!nershi- o+ the -ro-erty
#ounary"
This -rinci-le is use rarely, an has generally #een a--lie to lan
#ounaries, !here the original #ounaries are $any ecaes, or hunres o+
years, out<o+<ate"
This !oul not a--ly to cases !here regular -ay$ents !ere involve, such as
rent or interest, or !here clear arrange$ents !ere in -lace, such as trust
ees"
In these cases, an arrange$ent can continue +or hunres o+ years !ithout
change"
It !oul also not a--ly !here an ite$ !as loane +ro$ one -erson to
another, !here -ossession !as eli#erately taken, or to co$$ercial
transactions"
10
This -rinci-le only a--lies in cases !here an ite$ co$es into a -ersonCs
-ossession through the natural course o+ events"
An e3a$-le !oul #e ite$s that !ere le+t in a -ro-erty a+ter the -revious
tenants or o!ners ha vacate"
A!nershi- o+ ite$s generally re$ains !ith the original o!ner"
=o!ever, in so$e cases this $ay -ass to the -ersons having -ossession o+
the ite$ i+ an e3tene -erio o+ ti$e has gone #y"
In the earlier e3a$-le, i+ the ite$ arrive at an incorrect aress an
re$aine there +or a long -erio o+ ti$e, o!nershi- $ay #e eclare to have
-asse to the receiver"
2or e3a$-le, a -erio o+ $any $onths $ay -ass, a+ter !hich the receiver
$ay -ut the ite$ to -ractical use, such as incor-orating it into a #uiling
construction"
A+ter this ti$e, a court $ay orer that the sener ha lost their right to
retrieve the ite$, ue to the e3tene -erio o+ ti$e that ha -asse"
Another e3a$-le $ay involve ite$s that re$aine in a #uiling +or an
e3tene -erio o+ ti$e a+ter the -revious tenants or #uiling o!ner ha
vacate the #uiling"
In general, ho!ever, -hysical -ossession oes not a++ect o!nershi-, an the
o!nershi- o+ an ite$ only changes !hen it is #ought, sol or given as a gi+t,
regarless o+ its -hysical location"
/are shoul #e taken to ensure that this issue oes not arise against the
intention o+ the #usiness"
2or e3a$-le, in so$e cases, -arties have sei@e ite$s #y +orce, hel the$ +or
a -erio o+ ti$e, an a legal issue has arisen !ith the -ossi#ility o+ the
o!nershi- #eing eclare in +avour o+ the holers"
This can #e a -articular -ro#le$ !ith vacant #uilings, !here in so$e cases
legal action has #een taken against the o!ner o+ the #uiling in an atte$-t to
gain o!nershi- o+ the #uiling #y -arties taking -hysical -ossession o+ the
#uiling"
The risk o+ this situation occurring can #e reuce #y ensuring that
ocu$entation is in -lace +or all loans o+ -hysical ite$s, an that in cases
1*
!here -ro-erty is sei@e #y +orce, ste-s are taken to recover the ite$s !ithin
the shortest -ractical -erio o+ ti$e"
2.2.8.4. 3ratial ontrat issues
The ter$s :agree$ent; an :contract; have the sa$e $eaning"
Any agree$ent that is signe involving -roucts or services !ill generally
+or$ a legal contract"
This inclues so$e o+ the +ollo!ing situationsE
Being an e$-loyee or an e$-loyer"
5urchasing or selling a -rouct"
Being a client o+ a co$$ercial organisation #ase on a regular
+ee, such as a tele-hone connection"
$eading contracts
In so$e cases, reaing the +ull etails o+ a contract $ay not #e -ractical"
2or e3a$-le, !hen a s$all ite$ is -urchase in a sho- +or cash, a recei-t
$ay contain a large nu$#er o+ conitions liste as etails o+ the arrange$ent"
Signing the recei-t +or$s a contract, ho!ever this contract is generally
e3tinguishe as soon as the e3change o+ cash +or the -rouct is $ae"
So$e iniviuals $ay take an attitue that reaing a contract is a sign o+
istrust, an that this is a -ersonal insult"
=o!ever, in signing a contract, a -erson #eco$es #oun #y the +ull +orce o+
the la!"
Reaing a contract #e+ore signing it is a #asic +or$ality"
In $any cases a -erson taking this attitue is e++ectively asking the other
-arty to -lace their li+e in the hans o+ a co$-lete stranger"
1)
Regarless o+ this issue, the other -arty $ust usually eter$ine !hat the
ter$s o+ the contract actually are, an this cannot #e eter$ine !ithout
reaing it"
In this res-ect, reaing the ocu$ent involves +ining out !hat the ter$s o+
the contract actually are, regarless o+ other issues"
In general, every !or o+ a contract or agree$ent shoul #e rea #e+ore it is
signe"
Hner the la!, this #uren re$ains !ith the -erson !ho signs the contract,
an the other -arty is entitle to assu$e that the -erson !ill -er+or$ the
actions that they have agree to #y signing the contract"
Large transactions
In the case o+ large transactions, such as the sale o+ an air-ort, the contract is
generally evelo-e in one o+ t!o -ossi#le !ays"
In so$e cases, $eetings are arrange !here the t!o -arties sit in con+erence
an iscuss an argue the i++erent -oints to #e inclue in the contract"
This $ay #e an intense an tiring -rocess, !ith the +inal result having large
i$-lications +or #oth -arties"
This -rocess $ay continue +or several ays, or in so$e cases +or several
!eeks"
In other cases, a #roa contract is -ro-ose #y one -arty" This is then sent to
the other -arty +or consieration"
In so$e cases, hunres o+ -ages o+ trust ees, scheules, an actions to #e
taken uner a !ie variety o+ circu$stances $ay #e liste"
The other -arty !oul then revie! this contract, $ake a large nu$#er o+
s$all aitions an eletions, an then sen the contract #ack to the original
-arty several !eeks later"
The +irst -arty !oul then acce-t or re9ect the iniviual changes, an $ake
aitional changes"
This -rocess $ay continue !ith several revisions o+ the contract #eing $ae,
incluing iscussions over various -oints, until agree$ent !as reache to
acce-t the current contract as it stoo"
18
So$e o+ the ite$s that can #e inclue in a large an etaile contract
inclue the +ollo!ing -ointsE
Scheules o+ -ay$ents to #e $ae"
,ists o+ $aintenance ite$s, ti$e+ra$es an costs"
7etaile escri-tions o+ the ite$s, such as lan surveys an
e&ui-$ent lists"
%vents o+ e+ault I a list o+ events that !ill lea to action, such as
+ailing to $eet -ay$ents, +ailing to -rovie services accoring to the
agree scheules an so on" 2or each e+ault event, the action is
s-eci+ie, such as -enalty interest -ay$ents, or a--ointing an
alternative su--lier"
Service level agree$ents, s-eci+ying the ty-e o+ services -rovie,
the res-onse ti$es +or each service, an the +ees involve"
7etails o+ -ay$ent arrange$ents such as escro! accounts, -ay$ent
instal$ents, an cash +lo! irecte +ro$ the -ro9ect into s-eci+ic
accounts to $eet s-eci+ic -ur-oses such as e#t re-ay$ents"
7etails o+ +uning arrange$ents, such as -ay$ents to #e $ae on
e#ts or to investors, an the ti$ing an conitions uner !hich
-ay$ents !ill #e $ae"
,arge contracts such as this +ollo! the sa$e legal structure o+ o++er an
acce-tance as any other contract, an use the sa$e trust arrange$ents !hen
trustees an trust ees are involve"
Standard products and services
In the case o+ -urchasing stanar -roucts an services, in -ractice the
#usiness oes not have the o-tion to alter the contract"
The contract $ust #e acce-te or re9ecte as it stans"
=o!ever, there are t!o reasons +or care+ully reaing an consiering the
contract"
11
2irst, an ite$ in the contract $ay #e sur-rising an une3-ecte, an this $ay
alter the #usinessCs ecision to -urchase the -rouct or select the service"
In so$e cases, a i++erent service or ty-e o+ -rouct $ay #e selecte +ro$ the
sa$e su--lier, or a i++erent su--lier $ay #e selecte"
Secon, #eing a!are o+ the conitions in the contract $ay alter the current or
+uture actions o+ the #usiness"
2or e3a$-le, a $o#ile tele-hone contract $ay have a $ini$u$ ter$ o+
o-eration, #e+ore the contract can #e ter$inate !ithout -enalty"
This arrange$ent is generally use !hen the #usiness incurs a loss in the
early -art o+ the contract, an the early ter$ination -enalty is inclue to
reuce or eli$inate the loss ue to early ter$ination o+ the agree$ent"
In the $o#ile tele-hone e3a$-le, the #usiness !oul +un the cost o+ the
tele-hone irectly an generate an initial loss, !hich $ay #e recovere
through regular -ay$ents over a -erio o+ ti$e"
Being a!are o+ the $ini$u$ ter$, ter$ination -enalty an other issues $ay
not a++ect the ecision to -urchase a -rouct or select a service, ho!ever this
in+or$ation $ay #e i$-ortant in $aking other ecisions at the sa$e ti$e or
at +uture ti$es"
A #usiness that has signe contracts !ithout kno!ing the contents $ay
#eco$e highly vulnera#le, an $ay also loose the a#ility to act !ithout
incurring une3-ecte losses"
Dithout kno!ing the contents o+ the agree$ent that they are #oun #y, the
#usiness cannot $ake +ree ecisions"
A ecision $ay or $ay not lea to a loss, an the #usiness !ill have no !ay
o+ kno!ing !hether a -articular act !ill lea to a -ro#le$ or not"
The tele-hone e3a$-le also illustrates this"
4ot #eing a!are o+ the conitions, the #usiness $ay select a ne! tele-hone
su--lier, intening to cancel the -revious one"
=o!ever, a+ter signing an agree$ent !ith the secon su--lier, the #usiness
then iscovers that a ter$ination -enalty a--lies to the +irst contract"
The secon contract $ay also contain a ter$ination -enalty"
16
In this situation, the only alternatives $ay #e to -ay the ter$ination -enalty,
or -ay +or #oth services until the one o+ the contracts e3-ire"
So$e contracts use various legal ter$s, ho!ever the key +acts can generally
#e eter$ine +ro$ reaing the ocu$ent itsel+"
er"al contracts
In general, ver#al contracts in a co$$ercial setting +or$ legally #ining
contracts"
2or e3a$-le, i+ a custo$er !as to orer a -rouct #y tele-hone, then this
!oul +or$ a contract #et!een the su--lier an the custo$er"
In so$e cases, a re&uest to cancel a -rouct orer $ay #e acce-te i+ it is
given at an early stage"
In general, ho!ever, once a ver#al orer has #een -lace this +or$s a
contract, an elivery !oul -rocee an the custo$er !oul #e legally
o#ligate to -ay +or the -rouct"
Many #usinesses avoi the -ossi#ility o+ #a e#ts arising in cases such as
this #y re&uiring -ay$ent in avance #e+ore an orer !ill #e acce-te"
=o!ever, this a--roach $ay not #e -ractical in ealings !ith other
#usinesses or regular arrange$ents, !here invoices are nor$ally raise a+ter
elivery has #een $ae"
Defective and retuned goods
Dhen an ite$ is e+ective, the custo$er has the legal right to have the ite$
re-lace"
This occurs #ecause the original contract has not #een +ul+ille in the case o+
a e+ective -rouct"
The original contract that !as i$-lie #y the -rouct orer !oul #e +or the
e3change o+ an o-erational -rouct +or the -rouct -ay$ent"
In the case o+ a custo$er changing their $in regaring a -urchase, there is
no auto$atic right to return goos, as a clear e3change has #een agree an
then co$-lete"
60
Retail o-erations $ay have varying -olicies +or returne goos"
So$e #usinesses o not acce-t returne goos, others acce-t returns in
e3change +or other -urchases, !hile so$e -rovie cash re+uns"
2.2.8.5. Torts
A tort is a legal conce-t that involves an action that causes in9ury"
In this conte3t, the ter$ :in9ury; is use in its original an !ie $eaning o+
an event that causes a$age to another"
The legal use o+ the !or :in9ury; is not li$ite to -hysical in9ury"
This $ay involve +inancial loss, a$age to a -ro+essional or -ersonal
re-utation, or -hysical har$"
4egligence is an e3a$-le o+ a tort"
In a case o+ in9ury, legal action $ay #e initiate #y the in9ure -arty"
In situations !here in9ury is cause #y reckless action, or a lack o+
a--ro-riate actions an ue care, -ay$ents $ay #e a!are +ro$ the -arty
#eing sue to the -arty loging the clai$ to co$-ensate +or a$age"
=o!ever, the negligence is an e3tre$ely serious situation an the test +or
esta#lishing that negligence has occurre is &uite strict"
The actions involve $ust +all #elo! a $ini$u$ threshol o+ reasona#le
-er+or$ance, an the actions $ust have create a angerous situation or
+aile to -revent a$age occurring"
A stanar o+ e++ort or -er+or$ance that is #asic or lacking in so$e res-ects
is not generally su++icient to esta#lish negligence"
4egligence $ay a--ly to a -arty -er+or$ing a service in e3change +or
$oney"
(>> check -rouct lia#ility etc)
In this conte3t, an iniviual or #usiness coul #e sue #y a custo$er to
recover a$ages, i+ the custo$er su++ers in9ury as a result o+ the actions o+
the iniviual or #usiness"
61
(>> list o+ $a9or torts)
2.2.8.!. Trusts
In aition to loans an trae o+ -ro-erty, the la! also recognises the conce-t
o+ -ro-erty hel on trust"
In this case, the o!nershi- o+ the -ro-erty is trans+erre into the na$e o+
another -arty, kno!n as the trustee"
=o!ever, the trustee is then #oun to use the -ro-erty +or s-eci+ic -ur-oses,
rather than +or their o!n use, as outline in a ocu$ent kno!n as a trust
ee"
A trust ee is a set o+ state$ents that outlines the rules an -roceures to #e
use +or ealing !ith the +uns"
The la! o+ trusts is very ol, an trust la! originally s-eci+ie so$e
-articular etails +or +or$ing a vali trust ocu$ent, such as a re&uire$ent
that the ee #y !ritten on -a-er or -arch$ent, #ut not on other $aterials"
An e3a$-le o+ a trust !oul #e a situation !here -arents ie leaving young
chilren"
In this e3a$-le, the -arentCs +uns $ay #e trans+erre into the na$e o+ a
trustee, such as a relative"
=o!ever, these +uns !oul #e hel on #ehal+ o+ the chilren until they
reache the re&uire age"
The trustee !oul #e +ree to s-en the +uns +or -ur-oses irectly #ene+iting
the chilren, such as eucation e3-enses, #ut !oul not #e +ree to s-en the
$oney +or -ersonal use or any other -ur-oses"
Bank accounts an -ro-erty titles !oul #e hel in the na$e o+ the trustee"
Trusts are co$$only use to hol assets +or invest$ent $anage$ent, +or
trans+ers o+ assets through inheritance, an #usinesses are so$eti$es
o-erate through trusts"
In situations !here the trustee $isuses the +uns, this re-resents a #reach o+
trust an legal action can #e taken to recover the $issing +uns"
62
2.2.8.7. 'gen$
The la! recognises a situation !here one -arty acts on #ehal+ o+ another
-erson"
2or e3a$-le, a -erson $ay !ish to #i at an auction, #ut $ay #e una#le to
atten -ersonally"
In this case, the #ier $ay ask another -erson to atten an #i on their
#ehal+"
This -erson then hols authority as an agent o+ the #ier, an $ay sign a
legally #ining contract on their #ehal+"
In the case o+ a success+ul auction, the agent $ay sign a sale contract that is
#ining on the original #ier, not the agent the$selves"
/o$-le3 situations can arise !hen an agent -er+or$s actions that !ere not
re&ueste or authorise #y the original -erson"
The ter$ :agent; has a technical legal $eaning that is i++erent +ro$ the
co$$on usage in +iels such as real estate an insurance"
In these cases, the services are generally avisory, an the -erson oes not
have legal authority to sign contracts on #ehal+ o+ the #uyer or seller"
A -o!er o+ attorney is an e3a$-le o+ an agency arrange$ent, !here the
agent has legal authority an -o!er to conuct the -ersonCs a++airs, such as
traing -ro-erty an entering contracts"
%$-loy$ent is an agency arrange$ent, as !ell as a co$$ercial e3change o+
+uns +or services"
In general, an e$-loyee has the a#ility to -er+or$ actions that are #ining on
the #usiness, !ithin the constraints o+ the authority li$its that are -rovie to
the e$-loyee"
2or e3a$-le, a loan ocu$ent that is signe #y a #anking o++icer is a #ining
contract +or the #ank itsel+, not the iniviual that signe the ocu$ent"
63
2.2.8.8. Debt
In aition to lening -ro-erty, the conce-t o+ e#t is also recognise #y the
la!"
In this case, $oney is o!e +ro$ one -erson to another"
This $ay #e ue to re-ay$ent o+ $oney that !as originally #orro!e, or
$ay #e o!e +or other reasons, such as a -ay$ent +or goos that !ere
receive"
7e#t generally carries interest -ay$ents, an a scheule +or re-ay$ent o+ the
-rinci-al"
I+ -ay$ents are not $ae as re&uire, the -arty that is o!e the e#t can take
legal action to recover the +uns"
In the case that the +uns are not recovere, the creitor can loge a -etition
!ith a court to have the e#torCs a++airs !oun u- in a #ankru-tcy
-roceeing"
In this situation, the e#torCs assets are sol an use to re-ay the outstaning
e#ts"
2.2.8.9. +ompanies
A -ro-erly registere co$-any is recognise #y the la! as an ine-enent
entity, se-arate +ro$ any iniviual -erson"
This conce-t +irst e$erge in %nglish la! in the (>>check) century"
A co$-any can -er+or$ $ost o+ the actions that an iniviual can -er+or$"
A co$-any can o!n -ro-erty in its o!n na$e, it can enter contracts, it can
#e a trustee, an it can enter legal action in its o!n na$e"
This i++ers +ro$ trusts, agency arrange$ents, -artnershi-s, an other
situations, !hich all involve trans+erring legal authority +ro$ one -erson to
another -erson"
A co$-any is the only legal entity asie +ro$ iniviuals that has an
ine-enent e3istence, an can o!n -ro-erty irectly"
60
The assets o+ the co$-any are o!ne #y the shareholers"
A shareholer can #e an iniviual, or another co$-any"
The o!nershi- o+ a co$-any is ivie into a nu$#er o+ shares"
All shares are ientical" %ach share has one vote in the o-eration o+ the
co$-any, an has an e&ual share o+ the co$-anyCs assets"
In so$e cases, i++erent classes o+ shares are issue" This $ay involve voting
an non<voting shares, an -re+erence shares !hich inclue a i++erent
ivien rate to orinary shares"
Arinary shares +or$ the #ulk o+ availa#le shares, !ith other classes o+
shares #eing issue in a $inority o+ cases"
Iniviual shareholers $ay o!n $ore than one share, an so $ay o!n a
larger or s$aller -ro-ortion o+ the total assets than other shareholers"
Shares $ay #e unliste, in !hich case they can #e #ought an sol irectly
#et!een iniviuals, or liste on a stock e3change, !here they $ay #e
#ought an sol through the stock e3change"
Shareholers elect a #oar o+ irectors at an annual general $eeting to
o-erate the co$-any"
The irectors have authority to sign ocu$ents on #ehal+ o+ the co$-any"
In so$e cases, the irectors $ay also #e $a9or shareholers, an $ay o-erate
the co$-any -ersonally"
In other cases, irectors o-erate in a su-ervisory ca-acity, revie!ing the
o-eration o+ the co$-any an voting on $a9or ecisions such as the -urchase
an sale o+ -arts o+ the #usiness, an authorising $a9or -ro9ects"
2uns are contri#ute #y the shareholers, an #eco$e assets hel in the
co$-any na$e"
In turn, these assets are then inirectly o!ne through the shares that are
hel"
I+ the co$-any #eco$es insolvent an cannot -ay e#ts that are ue, it $ay
#e li&uiate"
In this case, all assets are sol, an all e#ts re-ai"
6*
Any re$aining +uns are then istri#ute to the shareholers"
/o$-anies generally have li$ite lia#ility"
In the case !here there is a e+icit an there are insu++icient +uns to re-ay
the total e#ts, the re$aining e#ts are cancelle, an no aitional +uns are
re&uire +ro$ the shareholers"
In other ter$s, the value o+ a share can +all to @ero, #ut it cannot +all to less
that @ero an re&uire aitional -ay$ent"
In -ractice, #anks lening to s$all an $eiu$ si@e co$-anies !ill o+ten
re+use to len !ithout -ersonal guarantees +ro$ irectors or shareholers"
This e++ectively $ay tie the irectorCs -ersonal assets to the co$-any" Shoul
the #usiness +ail an the co$-any #eco$e insolvent, the irectors -ersonal
assets can #e sol to re-ay the e#ts o+ the #usiness"
2.2.9. 3ositions of legal responsibilit$
2.2.9.1. /i(uiar$ (uties
In the eyes o+ the la!, each -erson is ine-enent"
A -erson #ears the #uren o+ their o!n e3istence, rather than the #uren o+
another -ersonCs e3istence"
=o!ever, the la! also recognises certain situations that involve a -erson
acting on #ehal+ o+ another"
The trustee o+ a trust is an e3a$-le o+ this situation"
In this situation, assets $ay #e hel in the na$e o+ the trustee, #ut $ay #e
governe #y the re&uire$ents o+ a trust ee"
2or e3a$-le, invest$ent +uns $ay #e trans+erre into the na$e o+ a trustee
+or the -ur-ose o+ $anaging the invest$ents"
The invest$ents !oul then #e $anage +or the #ene+it o+ the original
investors, not +or the #ene+it o+ the trustee"
6)
In these cases, although the legal o!nershi- is in the na$e o+ the trustee, the
e++ective o!nershi- #elongs to the #ene+iciary o+ the trust"
This situation is kno!n as #y the legal ter$ o+ a +iuciary uty"
A +iuciary uty arises !hen a -erson acce-ts a -ost that involves acting on
#ehal+ o+ another -erson"
2.2.9.2. #ervies
An agree$ent to -er+or$ services or su--ly -roucts oes not involve a
+iuciary uty"
%ach -arty re$ains ine-enent"
In the case o+ a -rouct or service not $eeting the agree stanar, the other
-arty $ay sue +or a #reach o+ contract to recover their loss"
The la! is not co$-letely clear in so$e cases, an atte$-ts have #een $ae
to sue -arties such as auitors an la!yers +or negligence an #reaches o+
+iuciary uty"
=o!ever, in general the la! vie!s the -rovision o+ services as a contractual
relationshi-, rather than a +iuciary relationshi-"
2.2.9.3. 3ositions
2iuciary uties arise in several ty-es o+ -osition"
These inclueE
A irector A irector has a +iuciary uty to $anage the
co$-any on #ehal+ o+ the shareholers"
A trustee A trustee has a legal uty to conuct actions
uner the trust ee +or the #ene+it o+ the
#ene+iciaries o+ the trust"
An agent An agent acts on the instructions o+ the
a--ointing -arty, !hen the -arty the$selves
68
cannot -ersonally atten a situation" An agent
has the legal authority to sign contracts an
-er+or$ actions that are #ining on the original
-arty"
Meical services In the case o+ li+e<threatening an other serious
situations, $eical services #ear a +iuciary
uty, in aition to a contractual relationshi-"

2.2.9.4. Duties
7uties o+ a -osition o+ legal res-onsi#ility inclue the +ollo!ingE
1" To act !ith ue care an iligence"
This involves -aying care+ul attention to the situation, avoiing reckless
an ha-ha@ar actions, an ensuring that the relevant ste-s are taken to
+ul+il the uties associate !ith the -osition"
2" To act accoring to instructions"
A irector $ust not act in contraiction to the $e$oranu$ o+
association o+ the co$-any, a trustee $ust +ul+il the ste-s lai out in the
trust ee, an an agent $ust +ul+il the instructions su--lie #y the
a--ointing -arty"
3" To avoi con+licts o+ interest"
In so$e cases, a -ersonal interest, or another -osition that is hel, $ay
con+lict !ith the -osition itsel+"
2or e3a$-le, a irector $ay also #e a irector o+ another co$-any that
launches a takeover o++er o+ the +irst co$-any, !hile a trustee $ay o!n
-ersonal assets that !oul #e suita#le +or -urchase #y the trust itsel+ as
an invest$ent"
A -erson holing a -osition o+ legal res-onsi#ility $ust avoi situations
that involve con+licts o+ interest, #y a#staining +ro$ iscussion or voting
on certain issues, #y avoiing transactions !hich involve a con+lict o+
interest, or #y resigning +ro$ the -osition"
61
The $e$oranu$ o+ association o+ a co$-any is a #rie+ ocu$ent that
inclues -roceural etails such as -roceures +or the a--oint$ent o+
irectors, ti$ing o+ annual $eetings, an voting arrange$ents"
2.2.9.5. 4n(epen(ent %u(gement
Although a -erson o!ing a +iuciary uty acts on #ehal+ o+ another -erson,
this oes not i$-ly that they act $echanically as the other -erson !oul in a
-articular situation"
A irector is legally re&uire to act ine-enently in the $anage$ent o+ the
co$-any, an not to act as an agent +or any other -arty, or in collusion !ith
any other -arty"
An agent $ust co$-lete any irect instructions that are s-eci+ie #y the
a--ointing -arty, ho!ever, !hen une3-ecte situations arise, an agent $ay
+or$ an ine-enent ecision as to the actions that !oul #e $ost
a--ro-riate in +ul+illing the instructions an acting +or the #ene+it o+ the
a--ointing -arty"
2.2.9.!. 8iabilit$
In cases !here a -erson in a -osition o+ legal res-onsi#ility +ails to -er+or$
the uties ae&uately, an the +iuciary su++ers in9ury as a result, then the
+iuciary $ay sue the -erson to recover the loss that has #een incurre"
In this conte3t, the ter$ :in9ury; inclues -hysical in9ury, +inancial loss, an
a$age to a -ro+essional or -ersonal re-utation"
This oes not a--ly to situations in !hich in9ury occurre, es-ite the -erson
+ul+illing the -osition accoring to the re&uire ste-s"
This action is taken on the #asis o+ negligence, or #reach o+ trust"
#egligence
4egligence occurs !hen the -erson acts recklessly or ha-ha@arly, or +ails to
-er+or$ the #asic ste-s re&uire to -er+or$ the -osition"
66
This $ust lea to the creation o+ a angerous situation, in !hich the +iuciary
su++ers in9ury as a result"
4egligence is a serious situation an the test +or negligence is &uite high"
=u$an error occurring uring correct an care+ul -roceures, or !ork that is
o+ a #asic stanar or e+icient in so$e res-ects is not su++icient to $eet the
stanar o+ negligence"
Breach of trust
Breach o+ trust occurs !hen the -erson holing the -osition o+ res-onsi#ility
+ails to act in the interests o+ the +iuciary, an acts +or their o!n #ene+it or
+or the #ene+it o+ a thir -arty"
2or e3a$-le, a trustee o+ a trust !ho use the assets o+ the trust +or -ersonal
uses !oul #e guilty o+ a #reach o+ trust"
2.2.9.7. +apait$
A -erson can hol $ore than one -osition at a -articular ti$e"
2or e3a$-le, an iniviual coul #e a irector o+ a co$-any, a trustee o+ a
trust, an also enter contracts in their o!n na$e +or -ersonal -ur-oses"
The -osition itsel+ is kno!n as a ca-acity"
A -erson holing a ca-acity has the legal -o!ers, an also the legal uties,
associate !ith that ca-acity"
2or e3a$-le, a irector o+ a co$-any can sign contracts that are #ining on
the co$-any itsel+, rather than the iniviual irector"
In cases !here $ore than one ca-acity is hel, it is co$$on to inicate the
ca-acity uner !hich a ocu$ent is #eing signe #y inicating a title or other
escri-tion #esie the signature"

2or e3a$-le, in theory a irector coul +or$ a legal contract #et!een a
co$-any an the$selves as an iniviual, #y signing the contract t!ice, one
in the ca-acity as a irector, an once in the ca-acity as a -rivate iniviual"
(>> check)"
100
2.2.1". Defamation
Business activity o-erates on the #asis o+ the ancient ,atin ter$ :caveat
e$-tor;"
This translates into %nglish as :#uyer #e!are;"
A -arty o++ering a -rouct or service +or sale, incluing the #usiness itsel+,
can generally #e e3-ecte to -resent the ite$ in its $ost +avoura#le light"
Also, #usiness o-erates on a co$-etitive #asis in t!o res-ects"
Businesses co$-ete !ith other #usinesses to !in sales +ro$ custo$ers an
clients"
Also, in ealing !ith a custo$er or a su--lier, a trans+er o+ value $ay occur"
This has an e&ual an o--osite e++ect on each -arty, so that a #ene+it receive
#y a custo$er or su--lier #eco$es a loss to the #usiness"
=o!ever, a #usiness cannot o-erate on a sustaine #asis i+ it carries a
re-utation +or acting ishonestly"
Business reputation within an industr*
Business is #ase on trae !ith others"
In any sustaine #usiness activity, re-eate transactions $ust #e $ae !ith
the sa$e custo$ers an su--liers"
/usto$ers an su--liers !ill not eal !ith a #usiness i+ there is a +ear that
they $ay #e tra--e an su++er loss ue to the actions o+ the other -arty"
In this conte3t, ishonest actions coul #e e+ine as so$e o+ the +ollo!ing
actsE
Making +alse state$ents"
Taking a series o+ ste-s, esigne to lea the other -arty into a
-osition in !hich they #eco$e tra--e an su++er a loss"
101
Defamation
7e+a$ation occurs !hen state$ents are $ae that are critical o+ the #usiness
or iniviual"
In general, any state$ent that har$s the re-utation o+ the #usiness or
iniviual coul #e consiere e+a$atory"
This inclues slaner, !hich involves s-oken state$ents, an li#el, !hich
involves !ritten state$ents"
An i$-ortant istinction occurs #et!een state$ents regaring actions an
+acts, an state$ents regaring $otives an character"
State$ents o+ o-inion regaring $otives an character $ay #e un-leasant in
so$e circu$stances"
=o!ever, each -erson is entitle to their o-inion, an is entitle to e3-ress it"
Dhen a state$ent relates to an actual event or +act, ho!ever, a i++erent
situation a--lies"
I+ a -erson clai$s that the #usiness or iniviual -er+or$e a certain act,
!hen in +act this i not occur, then a serious ste- has #een taken"
These actions can e++ectively ter$inate the o-eration o+ the #usiness"
7e+a$ation o+ this ty-e can lea to insolvency, li&uiation, an the
ter$ination o+ the #usinessCs or iniviuals a#ility to o-erate !ithin a
-articular inustry or !ithin #usiness activity in general"
Dhen a state$ent regaring a +act is $ae that is not accurate, an a$age to
the re-utation o+ the #usiness or iniviual occurs, the #usiness can sue the
-erson !ho $ae the state$ent, an recover the cost o+ the a$age +ro$ the
-erson !ho $ae the state$ent"
Defences to defamation

(>> check etails)
In general, any critical state$ent $ay #e consiere e+a$atory, unless the
-erson $aking the state$ent has reasona#le grouns +or #elieving that the
state$ents are true"
102
A ru$our hear +ro$ another -erson oes not $eet the legal stanar +or
reasona#le grouns"
In -ractice, this !oul involve escri#ing an event that the -erson ha
!itnesse !ith their o!n eyes, or a transaction that they ha #een -ersonally
involve in"
=earing in+or$ation +ro$ one -erson, an then re-eating this to another
-erson, is classi+ie as $aking a e+a$atory state$ent to the secon -erson"
The #uren lies !ith each iniviual to have reasona#le grouns +or #elie+
#e+ore $aking a critical state$ent"
Defamation in practice
7e+a$ation arises in co$$ercial situations in a nu$#er o+ circu$stances"
Ru$ours an general iscussion are an unavoia#le ele$ent o+ the #usiness
environ$ent"
In the case o+ s-eci+ic events, ho!ever, a i++erent situation $ay a--ly"
2or e3a$-le, a etaile re-ort $ay #e -re-are o+ a -rouct, service, o+ !ork
that the #usiness -er+or$e"
I+ this re-ort !as critical o+ the o#9ect #eing revie!e, an the re-ort !as
inaccurate, then the -arty -roucing the re-ort $ay #e sue +or e+a$ation"
In so$e inustries, revie!s o+ -roucts, services, or !ork -er+or$e $ay
have a signi+icant i$-act on the +uture inco$e o+ the #usiness"
As an author o+ in+or$ation revie!ing other iniviuals or #usinesses, the
#usiness shoul generally e3ercise great care in ensuring that +acts are
accurate, an that the overall i$-ression create an the conclusions re-orte
+or$e a reasona#le assess$ent o+ the situation"
Specific transactions
These issues $ay not generally a--ly in cases o+ s-eci+ic transactions, such
as -urchases an sales o+ assets"
103
In these situations, the nature o+ the ite$ an the -ay$ent ter$s #eco$e the
-ri$ary consierations, !ith issues involving the other -arty not #eing
relevant to the ecision to acce-t or re9ect the transaction"
Issues o+ e+a$ation $ay -articularly relate to service inustries, involving
regular transactions !ith esta#lishe clients, an situations in !hich the client
$ay #e e3-ose to -otential loss through the +uture actions o+ the #usiness"
2.2.11. 8ienes & 4ntelletual 3ropert$
The la! recognises intangi#le -ro-erty o+ various ty-es"
This inclues -atents o+ inventions, co-yright o+ artistic !orks, an licenses
to -er+or$ certain actions"
%3a$-les o+ artistic !orks recognise #y the la! inclue $usic, +il$,
esigns, -hotogra-hs, an co$-uter so+t!are"
This -ro-erty has si$ilar +eatures to other -ro-erty such as #uilings an
e&ui-$ent"
It is o!ne #y an iniviual or co$-any, an it can #e sol, loane or given
as a gi+t"
=o!ever, intellectual -ro-erty has so$e uni&ue +eatures"
Intellectual -ro-erty has an e3istence that is se-arate +ro$ its -hysical +or$"
2or e3a$-le, a recore $usic song, an a !ritten -age o+ notes, $ay #oth
involve to the sa$e creation, even though they have co$-letely i++erent
-hysical +or$s"
Also, intellectual -ro-erty can #e u-licate !ithout estroying the original"
Dhen a -hysical ite$ is sol, the inco$e is receive an the ite$ is lost"
=o!ever, -ro-erty such as $usic can #e u-licate an license +or a +ee,
an the original is not lost even through a +ee has #een receive"
,icensing intellectual -ro-erty is si$ilar to lening a -hysical ite$, such as
leasing a #uiling to a tenant"
100
The o!ner o+ the -ro-erty retains o!nershi- o+ the -ro-erty, ho!ever the
custo$er has use o+ the -ro-erty in return +or the +ee"
Intellectual -ro-erty can #e u-licate an license to $ore than one
custo$er"
Although intellectual -ro-erty can #e sol, in $ost co$$ercial situations the
-ro-erty is retaine #y the creator o+ the -ro-erty, an the custo$er is given a
license to use the ite$"
2or e3a$-le, o!nershi- o+ $usic is retaine #y the artist or recor co$-any,
!hile o!nershi- o+ co$-uter so+t!are $ay #e retaine #y the co$-any that
evelo-e it"
The cost o+ -urchasing a $usic isk or co$-uter -rogra$ involves the cost
o+ the -hysical isk, !hich is usually very lo!, an a license +ee +or the right
to use the -ro-erty"
2.2.11.1. 3atents
A -atent is a legal recognition that an invention has #een create, an
granting the inventor certain rights"
5atents $ust #e grante #y the -atents o++ice to have e++ect"
A -atent can generally #e grante +or any invention that creates a ne!
-rocess, $etho, or structure that !as not in e3istence #e+ore the inventor
create the esign"
5atents are not availa#le +or a -rocess or structure that is in co$$on use"
The $ain e++ect o+ a -atent is that it -revents other -arties +ro$ using the
invention !ithout the -er$ission o+ the inventor"
2or e3a$-le, $anu+acturing a -rouct #ase on a -atente esign, !ithout
the -er$ission o+ the inventor, !oul #e a #reach o+ the investorCs -atent
rights"
The inventor coul then sue the $anu+acturer to recover the loss that they
ha incurre through the invention #eing use !ithout -er$ission or the
-ay$ent o+ a +ee"
10*
5atente -rocesses are so$eti$es license to other $anu+acturers, !ho -ay a
regular license +ee +or the right to use the -rocess or esign in their
$anu+acturing"
This $ay involve -atente technology +or use !ithin a -rouction -rocess, or
the -rouct itsel+ $ay #e #ase on a -atente esign"
Meical rugs are an e3a$-le o+ a co$$on -atent situation in co$$erce"
In this situation, the co$-any that evelo-e the $eication $anu+actures
the -rouct +or the -erio o+ the -atent"
A+ter the -atent e3-ires, other $anu+actures $ay also $anu+acture the
-rouct"
5atents have a li$ite ter$"
At the ti$e o+ !riting in Australia, this is generally 20 years (>> check ter$)"
At the en o+ this -erio, the -atent la-ses, an the invention #eco$es -art o+
the -u#lic o$ain"
2.2.11.2. Tra(e mar6s & Bran( names
Bran na$es an trae $arks can #e registere as -ro-erty o+ the #usiness"
This inclues gra-hical logos, an the na$es o+ -roucts"
2or e3a$-le, !ell<kno!n #ran na$es $ay have consiera#le value, an
$ay #e liste in the #alance sheet as an asset o+ the #usiness"
I+ another $anu+acturer -rouce a re-lica o+ the #ran na$e or logo on their
o!n -roucts, this !oul #e an in+ringe$ent o+ the rights o+ the o!ner o+ the
registere trae $ark"
In these cases, the o!ner o+ the trae $ark coul sue the -erson !ho i$itate
the trae $ark"
This !oul generally result in a court orer +or the in+ringing -arty to cease
-roucing the goos !ith the i$itation #ran na$e or logo, together !ith an
orer +or -ay$ent o+ a$ages to the o!ner o+ the trae $ark to co$-ensate
+or lost sales"
10)
This situation also a--lies to -roucing close i$itations o+ gra-hical logos
an #ran na$es, as !ell as irect u-lication, i+ the i$itation coul lea to
custo$ers $istakenly selecting the alternative -rouct, in the #elie+ that they
!ere -urchasing the original -rouct"
2.2.11.3. +op$rig.t
/o-yright a--lies to artistic creations such as $usic, +il$, esigns, an
co$-uter so+t!are"
/o-yright a--lies as soon as an ite$ is create"
A creative -rouction oes not have to #e registere +or co-yright to a--ly"
The creator o+ the ite$ initially o!ns the co-yright to the ite$"
/o-yright gives the o!ner the right to control the use o+ the ite$"
2or e3a$-le, i+ other -arties $ake u-lications o+ the ite$ !ithout the
-er$ission o+ the co-yright o!ner, this !oul #e an in+ringe$ent o+ the
co-yright holerCs legal right to control the co-ying or istri#ution o+ the
!ork"
In the case o+ co-yrighte ite$s, the custo$er generally -urchases a licence
to use the ite$"
The custo$er in these cases -urchases a right o+ usage, rather than o!nershi-
o+ the -ro-erty"
Anly one -arty can o!n an ite$ o+ -ro-erty at any -articular ti$e, an a sale
o+ co-yright involves the o!nershi- o+ the co-yright -assing to the
-urchaser"
A!nershi- an licensing o+ co-yright is a signi+icant issue in the
evelo-$ent o+ co$-uter so+t!are an in inustries involving artistic
creations"
In the case o+ !ork -er+or$e on a aily #asis, such as general co$-uter
-rogra$$ing an gra-hics esigns !ithin avertising, co-yright generally
re$ains !ith the #usiness as -art o+ the contract o+ e$-loy$ent"
108
In the case o+ -ro9ects that are s-eci+ically co$$issione, the co-yright o+
the co$-lete !ork $ay generally -ass to the client as -art o+ the contract
+or evelo-ing the ite$"
In the case o+ ine-enent !orks, such as $usic creation, co-yright $ay
re$ain !ithin the original artist, !ith -arties such as recoring co$-anies
receiving +ees +or +uning initial evelo-$ents, -rouction an istri#ution"
=o!ever, $any i++erent situations an arrange$ents $ay occur in these
circu$stances"
/o-yright o-erates +or a li$ite -erio, an ter$inates +i+ty years a+ter the
eath o+ the -erson !ho create the !ork (>> check)"
A+ter this ti$e, the ite$ #eco$es -art o+ the -u#lic o$ain"
2.2.11.4. 8ienes to operate
In $any inustries, a license $ust #e hel #e+ore a #usiness can -er+or$ a
certain activity !ithout incurring a -enalty"
,icenses +all into a nu$#er o+ i++erent categories"
-ransfera"le and non-transfera"le licenses
So$e licenses are trans+era#le an can #e sol to another -arty, !hile other
licenses are not trans+era#le"
2or e3a$-le, a license to o-erate in a -articular trae or -ro+ession !oul not
nor$ally #e trans+era#le"
=o!ever, a licence to o-erate a +acility, such as a license to o-erate a ta3i, is
o+ten trans+era#le an coul #e sol to another -arty"
0nlimited licenses
Hnli$ite license re&uire certain conitions to #e $et in orer +or the license
to #e grante"
Any -arty $eeting these conitions is grante a license"
101
Banking is one e3a$-le" An organisation $ust hol a #anking license in
orer to -rovie #anking services to the general -u#lic"
A grant o+ this license re&uires certain conitions, such as a $ini$u$ level
o+ shareholerCs ca-ital, as a #u++er against #a e#ts"
=o!ever, any organisation $eeting the re&uire conitions !oul #e grante
a #anking licence, an there is no restriction on the nu$#er o+ #anks that
coul #e in o-eration"
The granting o+ licenses $ay #e #ase on o#9ective an su#9ective
conitions"
A#9ective conitions are +i3e criteria that can #e $et #y a #usiness a--lying
+or a licence"
2or e3a$-le, there $ay #e a $ini$u$ ollar value o+ shareholerCs +uns
re&uire +or a #anking o-eration, or a test !hich $ust #e -asse #e+ore a
licence !ill #e grante to -er+or$ a angerous activity"
Su#9ective criteria involves the -arty granting the licence +or$ing an o-inion
that the granting o+ an aitional licence !oul #e esira#le or unesira#le,
or +or$ing an o-inion a#out the a--licant the$selves !hen eciing to grant
or re9ect a licence a--lication"
2or e3a$-le, an a--lication to +or$ a ne! stock e3change coul #e re9ecte
on the grouns that co$-eting stock e3changes !oul s-rea traing
li&uiity $ore thinly, !hich coul reuce the overall e++iciency o+ the ca-ital
$arkets"
In the assess$ent o+ the a--licant the$selves, an e3a$-le !oul #e the
a--lication +or a license to o-erate a casino"
This -rocess involves an e3tre$ely thorough -ro#ity check to eter$ine any
links to cri$inal activity +ro$ the a--licants, ue to -ro#le$s that have
arisen !ith casino o-erations in the -ast"
=o!ever, this is still an o#9ective assess$ent in the sense that -articular
relevant issues are investigate, rather than a -ersonal ecision #eing $ae
regaring the a--lication that is not #ase on relevant issues"
$estricted licences
The secon ty-e o+ license relates to restricte licences"
106
This a--lies in cases !here a li$ite nu$#er o+ licenses are $ae availa#le"
Restricte licenses occur in t!o cases"
A restriction $ay #e #ase on a -hysical li$itation or other availa#ility
re&uire$ent"
2or e3a$-le, an air-ort has a +i3e nu$#er o+ ocking ter$inals +or aircra+t"
Hner one arrange$ent, each ter$inal coul #e license to a -articular
airline"
In that case, there !oul #e a li$ite nu$#er o+ -hysical +acilities that !ere
availa#le +or use"
This situation also occurs !ith other -hysical in+rastructure such as -orts an
rail links, an in the case o+ sections o+ raio +re&uencies +or television
#roacasting, raio, an $o#ile tele-hone co$$unication"
The other ty-e o+ restricte licence a--lies to li$its that are -lace on the
nu$#er o+ licences +or reasons that are se-arate +ro$ natural -hysical li$its"
This $ay #e one +or t!o reasons"
Ane reason is that a li$it $ay #e seen as esira#le +or -ractical -ur-oses"
Also, restricting the nu$#er o+ licenses $ay increase the value o+ each
license, !hich $ay ena#le revenue to #e erive +ro$ license +ees +ro$ the
initial granting o+ the license, an ongoing licence +ees, or a co$#ination o+
#oth"
2or e3a$-le, in so$e cases the nu$#er o+ ta3is that o-erate !ithin a city is
restricte to a certain nu$#er"
Allocation of licences
Restricte licences $ay #e a highly signi+icant issue in so$e inustries, an
in #usiness in general"
The value o+ a license can #e e3tre$ely high"
110
2or e3a$-le, a license to use a s-ectru$ o+ the raio +re&uencies +or $o#ile
tele-hone co$$unication can cost in the orer o+ a #illion ollars (>> check
etails)"
The value o+ a license to o-erate a single ta3i $ay cost G100,000" (>> check)
This inco$e +lo!s to the govern$ent #oy that issues the licence"
In so$e cases a single -ay$ent $ay #e re&uire, !hile in other cases an on<
going +ee $ay also #e ue"
The cost o+ a licence $ay #e a signi+icant #arrier to entry +or ne! #usinesses
that !ish to o-erate !ithin an inustry"
Restricte licences are allocate in various !ays"
Dhen ne! licenses are issue, they $ay #e issue +or a +i3e +ee, or they
$ay #e auctione to the highest #ier through an auction -rocess"
In a sta#le $arket !ith long ter$ o-erations, the licenses !ill generally trae
at a certain -rice, that re+lects that inco$e that can #e $ae +ro$ o-erating in
that inustry"
These -rices $ay rise an +all over ti$e, #ut re$ain at a reasona#ly sta#le
level"
A-erators !ishing to e3it the inustry o++er their licenses +or sale, !hile
#usinesses !ishing to enter the inustry -urchase a license that is availa#le
+or sale"
An alternative $etho o+ esta#lishing o-erations !ithin a $arket is to #uy a
#usiness that is currently license an o-erating !ithin the inustry"
Ane o+ the $ost co$$on reasons +or #uying another #usiness is to gain entry
to a ne! $arket"
This oes not involve a cost saving co$-are to -urchasing a licence
irectly, as the cost o+ the #usiness !oul inclue an a$ount that relate to
the value o+ the license"
=o!ever, this a--roach $ay avoi the co$-le3ity o+ esta#lishing ne!
+acilities an o-erations"
111
This $etho is -articularly relevant !here there are a s$all nu$#er o+
licenses that trae on an in+re&uent #asis, an a li&ui $arket in #uying an
selling licenses oes not e3ist"
$estricted Practices
In the case o+ a s$all nu$#er o+ licenses, there $ay not #e a regular $arket
o+ licenses #eing #ought an sol"
In the case o+ airline ter$inals, +or e3a$-le, there $ay #e a +e! o@en
ocking -orts, lease on long<ter$ leases #y a s$all nu$#er o+ airlines"
This !oul e++ectively -revent a ne! #usiness +ro$ co$$encing o-erations
!ithin this $arket"
In so$e situations, co$$ercial la! regulations inclue -rovisions that allo!
a #usiness to loge a clai$ +or access to a +acility that !oul #e necessary in
orer to o-erate !ithin a -articular inustry"
This generally occurs in cases involving in+rastructure ter$inals that cannot
#e u-licate ue to -hysical constraints, such as -orts an airline ter$inals"
2.2.12. +ommerial la5
2.2.12.1.1eneral la5
Ma9or areas o+ the la! a++ecting co$$ercial transactions inclue the
+ollo!ing areasE
/ontract la! An agree$ent #et!een t!o -arties, such as an
agree$ent to -rovie a service +or a regular +ee"
/ontract la! allo!s one -arty to recover losses
ue to the other -arty +ailing to co$-lete their
ter$s uner the contract"
Trust la! 5ro-erty hel in the na$e o+ a trustee" Trust la!
ena#les the #ene+iciaries o+ the trust to recover
+uns +ro$ the trustee i+ the trustee acts outsie
the ter$s o+ the trust ee"
112
%$-loy$ent la! Regulations relating to e$-loy$ent, incluing
health an sa+ety regulations, #ene+its such as
leave an su-erannuation, regulations governing
hiring an is$issal o+ e$-loyees, an other
e$-loy$ent<relate la!s"
%nviron$ental la! Regulations governing -ollution, an the use o+
natural resources"
4egligence The la! o+ negligence allo!s shareholers to sue
irectors !ho +ail to -er+or$ their uties
ae&uately, an recover losses +ro$ irectorCs
-ersonal assets"
/o$$ercial la! Regulations governing the registration o+
co$-anies, issuing -ros-ectuses an +unraising,
co$-any $ergers an takeovers, an traing
through stock an +utures e3changes"
Ta3 la! Regulations s-eci+ying the calculation an
-ay$ent o+ ta3"
In so$e cases +ailing to co$-ly !ith legal re&uire$ents $ay lea to civil
-enalties such as +ines, !hile in other cases, cri$inal la! a--lies"
2.2.12.2.,egulator$ issues
$egistration
In so$e cases #usiness activity can -rocee !ithout regulatory involve$ent"
=o!ever, in $any cases a #usiness $ust #e registere !ith a govern$ent
regulator an !ith ta3 authorities"
To create a co$-any, an a--lication +or$ $ust #e su#$itte to the relevant
regulatory authority"
This involves a list o+ #asic in+or$ation such as the na$e an registere
aress o+ the co$-any, the na$es an aresses o+ the -ro-ose irectors,
an the na$es, nu$#er o+ shares, an aresses o+ the +ouning shareholers"
113
A registration +ee also a--lies to cover a$inistration costs"
$eporting
7e-ening on the si@e o+ the enter-rise an the legal structure that is use,
accounts an annual returns $ay have to #e -rouce, an in so$e cases
su#$itte to regulatory authorities an stock e3changes"

In the case o+ s$all enter-rises, the re&uire$ents are generally $inor"
This $ay inclue su#$itting annual #usiness returns, ta3 returns, an other
ocu$ents"
In so$e cases, no$inal +ees a--ly to cover a$inistration costs"
Disclosure
In recent years, there has #een a tren to!ars $ore etaile an +re&uent
re-orting o+ in+or$ation"
2or e3a$-le, in -ast ti$es annual accounts !ere co$$on, !ith elays o+
several $onths $eaning that in+or$ation coul #e a year an a hal+ out<o+<
ate"
More recently, &uarterly re-orting has #eco$e co$$on, !ith elays +alling
+ro$ $onths to !eeks"
In Australia, an in $any other countries !ith si$ilar regulatory syste$s,
signi+icant in+or$ation $ust no! #e release as soon as it #eco$es availa#le"
This is in contrast to -revious -erios, !hen signi+icant in+or$ation !as
so$eti$es announce in an annual re-ort"

Any in+or$ation that coul have a signi+icant i$-act on the co$-any, an so
coul a++ect the share -rice, $ust not #e release as soon as it #eco$es
availa#le"
This !oul inclue in+or$ation such as takeover o++ers, settle$ent o+ court
cases, transaction o+ su++icient si@e to i$-act irectly on net -ro+it, an
resignations or hiring o+ senior -ersonnel"
110
This is generally one #y sening a ocu$ent in a +or$at si$ilar to a -ress
release to the stock e3change, !hich istri#utes the announce$ent an
associate ocu$ents to in+or$ation service -roviers"
This in+or$ation is generally availa#le on<line through on<line #rokers"
In+or$ation oes not nee to #e release i+ it relates to negotiations that are
in -rogress, or i+ it relates to a ne! -rocess or +or$ula that has value +or the
co$-any, an $ay result in a lost #ene+it i+ co$-etitors !here to -osses the
in+or$ation"
,nsider trading
Insier traing occurs !hen a -erson has kno!lege that is not -u#licly
availa#le an #uys or sells shares in the co$-any"
2or e3a$-le, the co$-any $ay receive a +avoura#le result in a $a9or court
case, an a -erson kno!ing this $ay #uy the shares #e+ore the -u#lic
announce$ent, to -ro+it +ro$ the rise in the share -rice"
This -ractice is -rohi#ite uner the co$$ercial la!"
In orer to avoi the -ossi#ility o+ insier traing #eco$ing an issue, an
e$-loyee, irector or any other -erson shoul only #uy or sell shares in the
co$-any !hen there are no $a9or ite$s o+ in+or$ation outstaning that have
not yet #een announce"
A co$$on internal re&uire$ent +or senior sta++, !ho $ay have kno!lege o+
the co$-anyCs year<to<ate traing +igures, is to allo! traing only uring
the +e! !eeks +ollo!ing a regular -ro+it announce$ent, to avoi the risk o+
insier traing #eco$ing a -ossi#le issue"
All -urchases an sales o+ shares #y irectors in their o!n co$-anies $ust
also #e re-orte to the stock e3change"
As in $ost situations, insier traing oes occur, an scanals a--ear +ro$
ti$e to ti$e"
/arket manipulation
Market $ani-ulation occurs !hen an atte$-t is $ae to alter a share -rice
arti+icially"
11*
This -ractice is -rohi#ite uner the co$$ercial la!"
In general, a -erson is entitle to #uy an sell any shares at any ti$e that they
!ish"
In the case o+ large transactions involving the shares o+ s$all co$-anies, the
transaction itsel+ $ay signi+icantly $ove the share -rice"
This e++ect is kno!n as :$arket i$-act;, an cases a loss +or the -erson
initiating the trae"
2or e3a$-le, in selling a large -arcel o+ shares, the -rice $ay #e -ushe
o!n as lo!er o++ers are $ae to attract enough #uyers to sell the entire
-arcel"
This causes a reuction in the average -rice receive #y the seller o+ the
-arcel"
The sa$e e++ect also occurs !ith large #uy orers, !ith a higher average
-rice #eing -ai #y the #uyer"
=o!ever, although atte$-ting to $ove a share -rice #y -lacing a large #uy
or sell orer $ay generate a loss +or the -arty initiating the trae, this $ay
still occur in so$e situations"
2or e3a$-le, an o-tions contract $ay #e #ase on a current share -rice, an
in cases !here the share -rice !as close to the trigger -rice on the ate o+ the
o-tion e3-iry, an atte$-t $ay #e $ae to $ove the share -rice across the
trigger -rice"
Market $ani-ulation an insier traing $ay attract the stanar co$$ercial
la! -enalties incluing +ines, cancellations o+ licences, an i$-rison$ent"
General regulations
The co$$ercial la! contains etaile -rovisions +or the ti$ing, ocu$ents,
an in+or$ation re&uire in a nu$#er o+ i++erent cor-orate activities"
These inclueE
2loating a co$-any on the stock e3change
Raising aitional e&uity +ro$ investors
11)
Raising e#t +ro$ investors
,aunching . res-oning to a takeover o++er
Annual accounts an re-orting
2.2.12.3.+ommerial praties
So$e co$$ercial -ractices are -rohi#ite, an $ay attract -enalties !hen
they are carrie out"
This varies +ro$ ti$e to ti$e an -lace to -lace, ho!ever it generally
inclues the +ollo!ing issues"
2.2.12.3.1. ,estritive tra(e praties
In so$e cases is it illegal to take action that -revents another -erson +ro$
o-erating a #usiness or carrying out a trae or -ro+ession"
This inclues ter$s !ithin e$-loy$ent contracts that !oul have the e++ect
o+ -reventing the -erson +ro$ o-erating !ithin an area or ti$e+ra$e a+ter
leaving the e$-loy$ent o+ the #usiness"
In so$e cases non<co$-etition clauses are allo!e, such as cases involving
the sale o+ a #usiness, !ith an agree$ent that the seller !ill not set u-
another #usiness in co$-etition !ith the e3isting #usiness !ithin a certain
area !ithin a certain -erio o+ ti$e"
2.2.12.3.2. -isuse of monopol$ or mar6et po5er
In cases !ere a #usiness $ay have o$inant share o+ a $arket, so$e
-ractices $ay #e +or#ien"
2or e3a$-le, action taken to -revent a co$-etitor +ro$ entering a $arket
$ay #e -rohi#ite"
This coul occur through e3clusive ealing agree$ents"
118
In other cases, the e3isting #usiness $ay lo!er -rices #elo! the cost o+
-rouction +or a -erio o+ ti$e, !ith the ne! #usiness #eing una#le to
survive in a loss<$aking o-eration +or a su++icient -erio o+ ti$e to esta#lish
a sustaina#le o-eration"
2.2.12.3.3. +ollusion
In general, collusion #et!een co$-etitors is +or#ien"
2or e3a$-le, a to!n $ay have -etrol stations o-erate #y three i++erent
#usinesses"
The #usiness coul $eet, an agree to all raise -rices at the sa$e ti$e"
This !oul not a++ect their sales, as -etrol !oul #e a necessity, an !oul
not #e availa#le +ro$ any other source"
Dith all -rices rising at the sa$e ti$e, custo$ers !oul not #ene+it +ro$
trans+erring +ro$ one su--lier to another"
This -ractice is kno!n as -rice<+i3ing an is -rohi#ite"
%ach co$-etitor $ust act ine-enently, an agree$ents or co<orinate
actions are not allo!e"
In the Hnite States, +or e3a$-le, these la!s are kno!n as anti<trust la!s
(>>check)"
2.2.12.4.8iabilit$ for statements
In certain circu$stances, +alse state$ents $ay attract a lia#ility +or a$ages"
In negotiations -rior to contracts, such as the sale o+ a #usiness, +alse
state$ents $ay #e $ae"
I+ the other -arty then su++ers a loss, such as -aying an e3cessive -rice +or the
#usiness, they $ay then take legal action to recover the a$ount o+ the loss
+ro$ the -arty that $ae the state$ent"
111
In another e3a$-le, +alse state$ents $ae to regulatory authorities an stock
e3changes $ay attract -enalties ranging +ro$ +ines, to elisting,
eregistration an i$-rison$ent in so$e cases"
In these situations, creating a +alse i$-ression an allo!ing a +alse
i$-ression to continue uncorrecte $ay also #e consiere +alse state$ents
#y the la!"
2or e3a$-le, i+ a -otential #uyer o+ a -ro-erty co$$ente on the large
a$ount o+ car -arking s-ace availa#le, ho!ever the -arking s-ace !as
actually associate !ith a i++erent #uiling, then the seller $ay #e
consiere to have $ae a $isre-resentation #y o$ission i+ they i not
correct the $istaken i$-ression"
=o!ever, situations such these $ay #e i++icult to -rove"
In general, state$ents in !riting that can clearly #e sho!n to #e +alse !oul
#e re&uire"
Also, the e3tent o+ the a$age that occurre $ust #e esta#lishe, an this
$ay #e i++icult to eter$ine"
2.2.12.5.8iabilit$ for in%ur$
In so$e cases, a #usiness $ay #e lia#le to -ay co$-ensation to a custo$er
!ho su++ers in9ury as s result +ro$ a +ault in a -rouct that !as -urchase
+ro$ the #usiness"
Also, custo$ers an $e$#ers o+ the -u#lic $ay sue the #usiness i+ they
in9ure the$selves !hile on the -re$ises o+ the #usiness"
5u#lic lia#ility insurance is availa#le that !ill $eet the cost o+ clai$s in
so$e o+ these circu$stances"
'arious health an sa+ety regulations a--ly to certain e$-loy$ent situations"
Also, a co$$on<la! uty o+ e$-loy$ent is to ensure that an unsa+e !ork
environ$ent oes not e3ist"
In cases !here the #usiness +ails to ae&uately aress these issues, an
in9ure e$-loyee $ay sue the #usiness to recover a$ages relate to in9ury"
Dorkers co$-ensation insurance is availa#le to $eet so$e o+ these clai$s"
116
In so$e cases, this insurance is co$-ulsory #e+ore a #usiness is -er$itte to
o-erate"
These sche$es $ay #e o-erate as a govern$ent insurance sche$e, or
-rivate insurance, e-ening on the iniviual situation"
Insurance to $eet lost inco$e an $eical e3-enses, as o--ose to a
negligence situation, is also availa#le"
This insurance is availa#le in various +or$s, such as -ersonal insurance
-olicies taken out #y the e$-loyee, an is o+ten inclue !ithin the structure
o+ retire$ent an su-erannuation +uns"
(>> check etails)
2.2.13. Emplo$ment
%$-loy$ent $ay involve several se-arate legal arrange$ents"
The relationshi- #et!een an e$-loyee an an e$-loyer is essentially a
contractual relationshi-"
A contract e3ists #et!een the e$-loyee an the e$-loyer, +or -er+or$ing
services in e3change +or -ay$ent"
In so$e cases, an e$-loyee is also a legal agent o+ the #usiness"
2or e3a$-le, a #ank grants authority to a #anking o++icer, uner the legal
conce-t o+ agency, to sign contracts !ith custo$ers on #ehal+ o+ the #ank"
In so$e cases a +iuciary relationshi- $ay also e3ist"
This generally a--lies to a legal uty to ensure that an unsa+e !ork -lace
oes not e3ist"

2.2.14. T.e la5 in pratie
The la! !as originally !ritten #y the King, !ho !as generally the -erson, or
a escenant o+ the -erson, !ho con&uere the country #y $ilitary +orce"
120
In tri#al societies, the la! $ay #e eter$ine #y a council o+ elers, or #y a
o$inant leaer holing the a#ility to choose the course o+ actions"
In the $oern conte3t o+ Australia an $ost other evelo-e Destern
nations, the la! is eter$ine in t!o !ays"
This inclues la!s vote on an -asse #y $e$#ers o+ -arlia$ent"
The la! is also eter$ine #y ecisions $ae #y 9uges in court cases,
!hich are #ase on la!s -asse #y -arlia$ent, -revious 9uge$ents, an the
circu$stances o+ the case"
A kno!lege o+ the la! is i$-ortant in #usiness +or t!o reasons"
Although the la! is o+ little use in $any #usiness situations, in other cases
legal action $ay #e success+ul in recovering losses ue to e+aults #y other
-arties to contacts an agree$ents"
An e3a$-le $ay #e a large evelo-$ent -ro9ect, !here a client $ay re+use
to -ay +or the co$-lete -ro9ect, on the grouns that the esign i not $atch
the esign that they e3-ecte"

7is-utes o+ this ty-e can take a consiera#le -erio o+ ti$e to resolve an
$ay involve long court cases"
Also, a #usiness $ay +in that legal action has #een taken against it, an
large -ay$ents coul #e orere against the #usiness unless care+ul attention
has #een -ai to ocu$entation an the arrange$ents that have #een -ut in
-lace"
2.2.15. -e(iation & 'rbitration
A nu$#er o+ +or$al a--roaches are availa#le +or resolving is-utes, in
aition to the legal syste$"
These a--roaches generally involve less co$-le3ity an +or$ality than the
legal syste$"
7is-utes $ay also #e resolve in a signi+icantly shorter -erio o+ ti$e, an
!ith less cost"
=o!ever, there $ay also #e severe isavantages +or a #usiness in #eco$ing
involve in an alternative is-ute resolution a--roach"
121
Although the legal syste$ can #e slo! an co$-le3, it has evolve over
several hunre years as a $etho o+ settling is-utes"
%ach o+ the rules an -roceures !ithin the court syste$ e3ists +or goo
reason, an an a--roach that oes not inclue these +or$alities $ay e3-ose
the #usiness to a higher level o+ risk, rather than a lo!er one"
/ediation
Meiation involves iscussion #et!een the t!o -arties in a +or$al setting"
This $ay involve a $eiator, !ho escri#es the -ur-ose an sco-e o+ the
iscussion, an atte$-ts to kee- the iscussion !ithin the to-ic an on
reasona#le ter$s"
The $eiator oes not #eco$e involve !ith the iscussion or -rouce a
9uge$ent o+ the case"
=o!ever, this situation $ay #e unlikely to -rouce a ne! resolution, other
than the #usiness si$-ly acce-ting the ter$s e$ane #y the other -arty"

7is-utes o not generally -rocee to a +or$al stage, such as $eiation or
legal action, until a long -rocess o+ iscussion has occurre"
Multi-le letters, tele-hone calls an conversations !oul generally have
occurre #e+ore a +or$al -rocess #egan"
The +act that the +or$al -rocess has #egun, inicates that the initial
iscussions have +aile to -rouce an agree$ent, an that the -arties have
chosen to -rocee to the ne3t stage"
I+ agree$ent !as reache uring -revious iscussions, $eiation !oul not
#e occurring"
In this environ$ent, the $eiation continues the -revious iscussions !ithin
a close an +or$al environ$ent"
The other -arty is unlikely to agree to ter$s that they have -reviously
re9ecte"
The #usiness $ay also not !ish to agree to ter$s e$ane #y the other
-arty, !hen iscussions have alreay covere the issues an +aile to -rouce
an agree$ent"
122
In these cases, a iscussion is likely to re-eat issues an vie!s that have
alreay #een iscusse $any ti$es -reviously, !ith little change"
7iscussions $ay also involve e$otional $ani-ulation, -ersonal inti$iation,
an re-eate iscussion o+ a !ie range o+ issues"
Dithin a close an +or$al environ$ent, !ith iscussions that $ay continue
+or a long -erio o+ ti$e, a risk +or the #usiness o-erator is that they si$-ly
give in to sustaine -ressure +ro$ the other -arty, an acce-t the ter$s that
are e$ane"
This !oul not #e a -ositive outco$e +or the #usiness"
In so$e cases $eiation $ay assist in resolving a is-ute, ho!ever in $any
cases this $ay #eco$e a #attle o+ !ills, !hich continues until one -arty gives
u- an acce-ts the otherCs ter$s"
In general, a -arty that is in a !eaker #argaining -osition $ay #e e3-ose to
greater risk !ithin a $eiation syste$, an a irect court action $ay #e a
sa+er alternative"
,ndependent #egotiators
Another a--roach coul involve a si$ilar -rocess, using ine-enent
negotiators such as the la!yers +or each -arty"
This a--roach has several #ene+its"
Hner this a--roach, -ersonal involve$ent an other issues are not involve
in the iscussion, !ith the t!o -arties a#le to iscuss the issues si$-ly an
clearly"
Also, in so$e situations, the legal or regulatory situation !oul #e +airly
clear, an a solicitor revie!ing the case !oul #e a#le to eter$ine !ith
reasona#le accuracy the ecision that a court !oul #e likely to $ake"
I+ this !as the case, then the negotiating -arties $ay #e a#le to co$e to a
co$$on -osition +airly &uickly, i+ each is a!are o+ the result that !oul
occur i+ the case continue to a court hearing"
The #usinessCs re-resentative !oul atte$-t to reach a -ro-ose settle$ent
!ith the other -arty"
123
This !oul then #e #rought #ack to the #usiness, an a ecision !oul #e
$ae in con9unction !ith the legal avisor to continue to a +ull court -rocess,
or acce-t the settle$ent as it stoo"
Ar"itration
Ar#itration involves a -rocess that is si$ilar to a court case"
State$ents an evience are -resente #y each -arty, !ith an ine-enent
9uge$ent #eing $ae #y the ar#itrator"
Ar#itration is use in various situations such as inustrial is-utes"
This -rocess $ay reuce the ti$e elays involve in a +ull court hearing"
Ar#itration is -articularly suita#le +or is-utes that o not re&uire large
a$ounts o+ evience to #e -resente, #ut !here the is-ute is #ase on a
nu$#er o+ other issues"
=o!ever, in a--roaching an ar#itration, the #usiness shoul e3ercise caution
to ensure that the +ull range o+ issues !oul #e -ro-erly aresse, rather
than a ecision #eing $ae in a short -erio o+ ti$e that $ay #e
un+avoura#le +or the #usiness"
In the case o+ a #ining ar#itration, each -arty agrees to acce-t the ecision
#e+ore the case co$$ences, an i+ the ecision is un+avoura#le, there $ay #e
no !ay to reverse the ecision a+ter!ars"
2.2.1!. 4nitiating legal ation
,egal action is co$$on in so$e o+ the +ollo!ing circu$stancesE
7e+aults on -ay$ents, !here -ay$ents are ue #ut are not $ae"
Insolvency, !here atte$-ts are $ae to involve a !ie range o+
-arties in the insolvency -rocess"
Foint ventures, !here t!o #usinesses conuct a venture such as
creating a istri#ution #usiness, an is-utes arise over -articular
ter$s an issues"
120
,arge -ro9ect evelo-$ent, !here is-utes arise over the esign o+
the -ro9ect, the ti$ing o+ events, an &uestions o+ !hich ite$s are
an are not inclue !ithin the -ro9ect"
,egal issues +or$ a $a9or -art o+ large co$$ercial transactions"
In these circu$stances, a large -ro-ortion o+ the ti$e $ay involve
conversations !ith co$$ercial la! +ir$s, altering clauses in contracts an
trust ees an ensuring that a !ie range o+ scenarios have #een covere in
the ocu$entation"
=o!ever, the ste- to initiating court action is a serious ste-, an is not
generally taken lightly"
A-art +ro$ the ti$e an cost involve, this generally ter$inates the
relationshi- #et!een the -arties in relation to the current -ro9ect, an
-ossi#ly +or a signi+icant ti$e a+ter that"
This is a -articularly serious issue !ithin inustries that $ay only involve a
+e! organisations"
/o$$ercial la! action generally -rocees on a civil #asis, !ith letters
outlining issues clearly, an ocu$ents #eing elivere or -ay$ents $ae as
re&uire #y circu$stances or court orers"
=o!ever, this ste- generally $arks the en o+ iscussions an negotiations
#et!een the -arties"
Dhen this ste- is taken, an arrange$ent such as a 9oint venture co$-any or
evelo-$ent -ro9ect $ust o+ten #e consiere to have ene, !ith the court
action si$-ly involving the li&uiation an #reak<u- o+ the -ro9ect so as to
$ini$ise losses"
In the case o+ s$aller transactions, legal action usually involves recovering
s-eci+ic -ay$ents, !ith court orers #eing issue accoring to the case"

2.2.17. T.e legal proess
The legal -rocess involves contacting a solicitor, !ho -re-ares a case
regaring the clai$"
12*
In the case o+ a s$all transaction, a solicitor in -rivate -ractice is o+ten
consulte, !hile in the case o+ larger transactions, co$$ercial la! +ir$s are
use"
2or e3a$-le, a contract $ay have #een entere +or the su--ly o+ a certain
ty-e o+ e&ui-$ent, ho!ever the e&ui-$ent that !as su--lie $ay have #een
signi+icantly i++erent +ro$ the s-eci+ication"
The su--lier $ay re+use to e3change the e&ui-$ent, an $ay e$an
-ay$ent"
%vience !oul nee to #e asse$#le in the +or$ o+ co-ies o+ letters,
contracts, s-eci+ications, an ine-enent e3-ertCs re-orts an assess$ents"
A clai$ !oul then #e +ile !ith a court"
Dhen the hearing co$$ences, evience is -resente, !itnesses are
&uestione an a ecision is $ae #y a 9uge or 9ury"
In co$$ercial $atters a 9ury is not usually involve"

The case !oul then #e eter$ine in +avour o+ one o+ the -arties"
The court $ay orer action to #e taken, such as e&ui-$ent to #e returne or
elivere"
More co$$only, an a$ount o+ a$ages is a!are as co$-ensation +or the
loss that has occurre"
This involves a -ay$ent #y the e+enant to the -arty !ho +ile the clai$,
#eing the other -arty to the contract, as co$-ensation +or the loss cause #y
the e+enantCs +ailure to +ul+il the contract re&uire$ents"
This $ay or $ay not involve an a!ar +or costs, !hich re&uires the loosing
-arty to -ay the legal costs o+ the success+ul -arty, in aition to the
co$-ensation +or the loss escri#e in the clai$"
/ourt orers $ay not #e carrie out initially, an a long elay involving
re-eate court a--earances $ay occur #e+ore -ay$ent is +inally receive"
7e+ening a clai$ against the #usiness involves a si$ilar -rocess"
12)
2.2.18. 'ttitu(e of t.e la5
Decisions and contracts
The attitue o+ the la! is to generally not $ake 9uge$ents on the ecisions
$ae #y a -erson, #ut si$-ly to en+orce the choices that have #een $ae"
2or e3a$-le, in the case o+ a contract, a court !ill not e3a$ine the $eaning
or signi+icance #ehin the ter$s o+ a contract, e3ce-t in rare cases o+ uress
or o--ression, an #ut $ay en+orce that each -arty $eet the conitions that
they chose to agree to"
-echnical terms in agreements
Inter-retation o+ ocu$ents is generally very s-eci+ic, an technical issues
!ith !oring an so +orth $ay #e inter-rete &uite literally"
Also, !oring in other ocu$ents such as trust ees is also generally
inter-rete &uite literally"
Statements
=o!ever, in the case o+ general state$ents such as in+or$ation -rovie
a#out an ite$ +or sale, the la! $ay take a !ie inter-retation o+ the
i$-ression that !oul #e create #y the -ersonCs actions"
2or e3a$-le, in so$e circu$stances, si$-ly re$aining silent an +ailing to
correct an o#vious $isunerstaning #y a -otential custo$er !oul #e
consiere e&uivalent to $aking a +alse state$ent, !hile a state$ent that !as
technically correct #ut -rovie a $isleaing i$-ression $ay also #e
classi+ie as a +alse state$ent"
These issues $ay #eco$e relevant in relation to contracts, !here a contract
$ay not #e #ining in so$e circu$stances i+ the other -arty $ae +alse
state$ents in iscussions -rior to agree$ent to the contract"
,egal action is co$$on in #usiness, an a #usiness o-eration o+ any
signi+icant si@e $ay +in itsel+ a--earing in court on a regular #asis, as an
a--licant or as a e+enant"
128
2.2.19. #ummar$ of ommerial la5
The la! is a co$-le3 an vague thing"
Also, $uch o+ the la! is not !ritten in any one -lace, #ut is #ase on the
-rinci-les that have e$erge +ro$ $any cases an legal 9uge$ents"
=o!ever, the $a9or -rinci-les o+ the la! as it a--lies to #usiness situations
can #e su$$arise in the +ollo!ing three -rinci-les"
1" In general, any contract or agree$ent that is signe is legally
#ining"
I+ a -arty +ails to co$-lete an action that is liste in the
contract, the other -arty $ay sue the$ to recover the loss that
has #een incurre"
,ike!ise, i+ the other -arty +ails to co$-lete an action, the
#usiness can take legal action against the$" =o!ever, $ay #e a
slo! an e3-ensive -rocess an is not al!ays -ractical"
2" I+ an iniviual or co$-any hols a -osition o+ legal
res-onsi#ility, an the -arty to !ho$ they o!e the
res-onsi#ility is in9ure #y their conuct, then the other -arty
$ay sue to recover the loss that has #een incurre"
In this conte3t, in9ury inclues +inancial loss as !ell as
co$-ensation in relation to -hysical in9ury"
5ositions o+ legal res-onsi#ility inclueE
A trustee o+ a trust"
A irector o+ a co$-any"
An agent uner an a--oint$ent to act as an agent"
An e$-loyer (regaring health . sa+ety regulations
etc)"
In e+ence to this, a -erson $ay not #e lia#le i+ the +ollo!ing
circu$stances a--lyE
121
They e3ercise reasona#le attention an iligence to
+ul+illing the -ost (kno!n as ue care or ue
iligence)"
An, they co$-lie !ith the re&uire$ents s-eci+ie in
any associate instructions, such as the trust ee +or a
trustee, or the co$-any articles o+ association +or a
irector"
3" 'arious govern$ent regulations a--ly to #usiness, incluing
su#$itting a range o+ registration an -roceural in+or$ation,
an a#staining +ro$ -er+or$ing certain #usiness -ractices, such
as -rice +i3ing in collusion !ith co$-etitors"
5enalties a--ly +or #reaching these regulations
126
2.2.2". 8egal terms
Acce-tance A clear state$ent that a -arty acce-ts an o++er that is
$ae #y another -arty" A contract co$es into
e3istence !hen an o++er is acce-te"
Aversarial
syste$
A trial syste$ use in the Hnite States that vie!s a
court case as a contest #et!een t!o -arties" The
9uge rules on technical issues an $aintains orer in
the -rocess, !hile the -arties -resent their cases to
the 9ury +or 9uge$ent"
Agent A -erson !ho acts on #ehal+ o+ another -erson an
has authority +ro$ the +irst -erson to -er+or$ legally
#ining acts on their #ehal+" This $ay involve
signing contracts o+ -er+or$ing other acts in -lace o+
the +irst -erson, an has the e++ect as i+ the +irst
-erson -er+or$e the act" Any -erson can #e an
agent +or any other -erson, i+ authority is given #y
the +irst -erson"
Bene+iciary A -erson !ho is entitle to the #ene+it o+ +uns hel
!ithin a trust" 2uns hel uner a trust ee are hel
in the na$e o+ the trustee, an uner the control o+
the trustee, ho!ever they are hel +or the #ene+it o+
the #ene+iciaries"
Black<letter la! 7ocu$ente statutory la!, as -asse #y -arlia$ent"
Breach o+ contract 2ailing to -er+or$ an action s-eci+ie in a contract"
Breach o+ trust 2ailing to -er+or$ a +iuciary uty +or the #ene+it o+
the +iuciary, #ut acting in the interests o+ another"
2or e3a$-le, a trustee !ho use the assets o+ the
trust +or -ersonal -ur-oses !oul #e guilty o+ a
#reach o+ trust"
/a-acity 1" The a#ility to +or$ a legally #ining
contract" This re&uires that the -erson #e
over the age o+ legal ca-acity, generally 11
years o+ age, an that they not #e
into3icate or #e $entally inca-acitate"
2" A -osition that is hel that carries associate
legal -o!ers an uties, such as a irector,
trustee or agent"
/hattels Ite$s attache to a #uiling that are inclue !ith
the sale o+ a -ro-erty, such as light +ittings an
curtains"
130
/o$$on la! The -rinci-les an la!s erive +ro$ -ast court
9uge$ents" This co$$on la! is not ocu$ente in
a single -lace, #ut certain -rinci-les have e$erge
+ro$ a large nu$#er o+ cases"
/o$-any A legally recognise entity that is se-arate +ro$ any
iniviual, an can o!n assets, enter contracts, act as
an agent or trustee, an enter legal action"
/onsieration The other ite$ o+ value !ith a contract, such as the
-ay$ent $ae in e3change +or an ite$"
/onte$-t o+ court 2ailure to carry out an action orere #y a court"
(>>check)
/ontract An agree$ent, generally an agree$ent to su--ly an
ite$ or service in return +or -ay$ent"
/ourt orer An instruction +ro$ a court orering that an action #e
-er+or$e, such as -aying a su$ o+ $oney as
co$-ensation, or ceasing to -rouce a certain
-rouct"
7a$ages Money re&uire to #e -ai as co$-ensation +or loss"
7ee A ocu$ent containing a eclaration or set o+
state$ents that are intene to have legal e++ect, such
as a trust ee regaring -ro-erty hel on trust"
7e+ault An event !here an action that is re&uire uner a
contract oes not take -lace, such as +ailing to $ake
a -ay$ent ue on a e#t re-ay$ent, or +ailing to
eliver a -rouct accoring to a contract scheule"
7uress Hsing +orce, inti$iation or other $eans to inuce a
-erson to enter a contract" A contract is not
en+orcea#le i+ it is entere uner uress"
%&uity A se-arate court syste$ +ro$ the co$$on la!
syste$ that o-erate in %nglan +or a -erio o+ ti$e"
In recent ti$es a single court syste$ has o-erate,
ra!ing on -rinci-les an 9uge$ents +ro$ -revious
co$$on la! an e&uity 9uge$ents
2iuciary uty The relationshi- #et!een a trustee an the
#ene+iciary, a irector an the shareholers, or other
situation in !hich a -erson hols a -ost, !ith the
uties o+ that -ost involving acting in the interests o+
another"
In&uisitional
syste$
A trial syste$ use in so$e Asian countries that
vie!s a court case as an e3a$ination o+ the accuse,
!ith the accuse #eing &uestione #y a 9uge or 9ury"
(>> check etails)"
Instru$ent A ocu$ent that creates legal i$-lications, such as a
contract or trust ee"
131
,ia#ility A situation in !hich a$ages $ay #e a!are
against a -arty, an -ay$ent $ay #e re&uire as
co$-ensation +or loss"
,icense A right to -er+or$ certain actions !ithout -enalty,
such as a license to use a raio +re&uency s-ectru$"
,itigation /onucting legal action, through loging a clai$
!ith a court, such as clai$ing that a #reach o+ a
contract has occurre, an re&uesting a court hearing"
4egligence 2ailure to -er+or$ a service or uty care+ully an
sa+ely, leaing to a angerous situation an in9ury"
A++er 1" A clear state$ent that a -arty is -re-are to
enter a transaction" 2or e3a$-le an o++er to
sell an ite$ at a s-eci+ie -rice, or an o++er
to #uy an ite$ at a s-eci+ie -rice"
2" An o++er to sell" In +inancial $arkets traing
an auctions, an o++er to #uy is kno!n as a
:#i;, !hile an o++er to sell is si$-ly kno!n
as an :o++er;"
5arty An iniviual, co$-any, trust ee arrange$ent,
-artnershi-, or other arrange$ent that acts as a single
entity !ithin a legal arrange$ent or other situation"
2or e3a$-le, a contract o+ e$-loy$ent $ay #e
#et!een t!o -arties, a co$-any an an iniviual,
!hile a contract o+ sale $ay #e #et!een t!o
co$-anies"
5atent A legal right to -er+or$ certain actions !ith an
invention, such as $anu+acturing it e3clusively +or a
+i3e -erio o+ ti$e" A -atent $ust #e a!are #y
the -atents o++ice #e+ore it #eco$es e++ective"
5receent ,a! is #ase on -receent, !hich states that the
9uge$ents o+ -revious court cases +or$ a set o+
la!s that are #ining on +uture 9uge$ents"
5re$ises A #uiling that is occu-ie #y a #usiness"
5ro-erty Anything o+ value that is o!ne #y the #usiness,
such as e&ui-$ent, cash, -atents, lan an #uilings"
Recision A court orer that cancels a contract (>>check)
Recitals A list o+ e+initions at the #eginning o+ a large
contract or trust ee, e+ining the $eaning o+ ter$s
use !ithin the ocu$ent
Statutory la! The la! -asse #y -arlia$ent"
Sue To loge a clai$ against another -arty !ith a court"
Ter$ A $a9or ele$ent o+ a contract" The #reach o+ a ter$
coul lea to ter$ination o+ the contract an an
a!ar o+ a$ages"
132
Title A!nershi- o+ an asset" A!nershi- o+ lan is
recore #y a title, an in general usage, to have title
to an ite$ o+ -ro-erty is to o!n it"
Tort A ty-e o+ action this is recognise #y the la! an
that cause a$age" In situations involving torts, a
-arty su++ers a$age ue to the actions o+ another
-arty, an $ay sue the +irst -arty to recover the
e3tent o+ their loss" %3a$-les o+ torts are negligence
an e+a$ation"
Trae $ark A registere #usiness logo or sy$#ol" /o-ying or
i$-ersonating a trae $ark can result in an a!ar o+
a$ages against the in+ringer"
Trust A legal situation in !hich assets are hel #y one
-erson on #ehal+ o+ another"
Trustee A -erson !ho hols assets in their o!n na$e, +or
s-eci+ie -ur-oses or +or the #ene+it o+ another
-erson" The rules setting out the $anage$ent o+ the
+uns are inclue in a trust ee"
Darranty A $inor ter$ o+ a contract" A #reach o+ a !arranty
$ay not nor$ally leaing to the ter$ination o+ the
entire contract
133
.!. O%nership
Business can #e o!ne through a variety o+ structures"
A!nershi- o+ a #usiness i$-lies t!o things"
This inclues the o!nershi- o+ the #usiness assets"
A!nershi- o+ a #usiness also involves the a#ility to -er+or$ legal actions on
#ehal+ o+ the #usiness, such as signing contracts"
Assets
Assets $ay inclue cash holings, e&ui-$ent, -rouction +acilities, an
intangi#le assets such as -atents"
In aition to o!ning the irect assets o+ the #usiness, an o-erating #usiness
$ay have a value #eyon its static assets"
2or e3a$-le, a cash +lo! #ase service #usiness o-erate through a co$-any
structure $ay have +e! assets"
=o!ever, the co$-any itsel+ $ay have value in the case o+ a success+ully
o-erating #usiness !ith -ositive cash +lo!"
A!nershi- o+ the #usiness $ay involve the irect assets, an also the value
o+ the #usiness structure as an o-erating enter-rise"
Legal capacit*
A!nershi- also i$-lies the legal ca-acity to -er+or$ actions on #ehal+ o+ the
#usiness, such as $aking -ay$ents an signing contracts"
This legal ca-acity is o+ten elegate to e$-loyees #y granting authority, as
an agent, to sign ocu$ents an $ake -ay$ents on #ehal+ o+ the #usiness"
2.3.1. #ole tra(er
A sole traer conucts a #usiness activity -ersonally" All +uns an contracts
are hel in the traerCs -ersonal na$e"
130
A #usiness na$e $ay #e registere an use +or traing -ur-oses, ho!ever
this is si$-ly an alternative na$e use +or #usiness -ur-oses"
A #usiness na$e cannot #e use to o!n -ro-erty or enter contracts, an a
#usiness na$e is not recognise as a se-arate -erson #y the la!"
In so$e cases, the #usiness an -ersonal assets $ay #e co$#ine"
In other cases, se-arate accounts an assets are hel +or -ersonal an #usiness
-ur-oses"
2.3.2. 3artners.ip
A -artnershi- involves several iniviuals !orking in a co$$on enter-rise"
5artnershi-s are recognise #y the la!, ho!ever they are not a se-arate legal
entity, an assets cannot #e o!ne in the na$e o+ the -artnershi-"
Assets in the case o+ a -artnershi- $ay #e o!ne 9ointly in the na$es o+ the
-artners" (>> check etails o+ asset titles . o!nershi- +or -artnershi-s)
5artnershi-s o not have li$ite lia#ility"
A -artner $ay #e -ersonally lia#le +or e#ts #eyon the si@e o+ the
invest$ent in the -artnershi-, an +or e#ts incurre #y other -artners"
Also, trans+erring an selling the interest in a -artnershi- $ay #e i++icult"
=o!ever, istri#uting inco$e through a -artnershi-, an aing an
re$oving +uns +ro$ the enter-rise $ay #e easier !ith a -artnershi- than
!ith a co$-any"
5artnershi-s are co$$only use in -ro+essional -ractices, such as +ir$s o+
solicitors"
This o+ten a--lies to situations !here the -artners -er+or$ services
-ersonally an share a$inistrative an other e3-enses"
2.3.3. 3rivate Trusts
13*
So$e #usinesses are o-erate through a trust, !ith the #usiness assets #eing
hel uner a trust ee in the na$e o+ a trustee"
This allo!s the inco$e +ro$ the #usiness to #e istri#ute to #ene+iciaries o+
the trust in a varia#le !ay, in contrast to co$-anies in !hich case a ivien
-ay$ent is the +i3e a$ount -er share"
2.3.4. 7nit trusts
In so$e case, -articularly in the case o+ #usiness structures that are use
-ri$arily to hol assets such as -ro-erty or in+rastructure assets, a unit trust
is use rather than a co$-any"
In this case, the assets are hel in the na$e o+ a trustee"
The trust assets are then ivie into a large nu$#er o+ units"
Hnits $ay #e liste or unliste"
In the case o+ unliste units, an a--lication is $ae to the #usiness $anaging
the invest$ent to su#scri#e +or ne! units"
Dithra!ing +ro$ the invest$ent involves su#$itting a re&uest to !ithra!
the invest$ent +uns"
A--lications an ree$-tions are $ae on the #asis o+ the net asset value o+
each unit, -ossi#ly !ith a variation ue to +ees"
In the case o+ liste units, the units $ay #e liste +or traing on a stock
e3change"
In -ractice this is a si$ilar arrange$ent to liste shares"
Hnits $ay #e #ought an sol through the e3change, istri#utions $ay #e
-ai in a si$ilar !ay to iviens, an the units $ay rise or +all in value in
line !ith the trust assets"
In the case o+ unliste units, a--lications or ree$-tions o+ any -ractical si@e
$ay usually #e $ae, an the unit -rice oes not iverge +ro$ the value o+
the trust assets"
13)
=o!ever, a large nu$#er o+ ree$-tion re&uests !ithin a short -erio o+
ti$e $ay lea to li&uiity -ro#le$s !ithin the trust, as assets such as
-ro-erty cannot #e sol !ithin a short -erio o+ ti$e"
,iste units $ay have #ene+its in si$-le #uying an selling -rocesses an
short settle$ent -erios co$-are to unliste units"
Also, the trust assets o not nee to #e sol !hen a liste unit is sol to
another investor"
=o!ever, liste units $ay lea to traing li&uiity -ro#le$s !hen a large
nu$#er o+ units nee to #e #ought or sol, an also the unit -rice $ay
iverge +ro$ the unerlying value o+ the net assets -er unit"
2.3.5. +ompan$
/o$-anies are use +or $ost large enter-rises, an are also use #y sole
traers an other #usinesses"
A co$-any has the #ene+its o+ li$ite lia#ility, the a#ility to #uy an sell the
shares, an a clear se-aration #et!een the #usiness structure an -ersonal
assets"
7isavantages !ith co$-anies inclue a greater i++iculty in trans+erring
ca-ital into an out o+ the co$-any, an in+le3i#le istri#ution o+ inco$e to
i++erent shareholers, an re&uire$ents +or annual returns, accounts, annual
$eetings an re-orts"
.". Control
/ontrol o+ a #usiness involves the a#ility eter$ine the actions that the
#usiness conucts"

%3ce-t in the case o+ a sole traer or a single shareholer co$-any, this
involves t!o or $ore -eo-le"
Several arrange$ents e3ist +or the control o+ #usiness activities"
Directions and disputes
138
In so$e cases, #itter is-utes an -o!er struggles can arise !ithin the
o-eration o+ a #usiness"
Businesses o+ten involve +a$ily $e$#ers, close associates, an other
investors"
7i++erences in o-inion an esires +or the +uture irection can lea to serious
-ro#le$s"
In $any cases an investorCs entire -ersonal assets $ay #e tie u- in the
#usiness"
Ma9or i++erences o+ o-inion $ay arise as to !hich courses o+ action !oul
lea to gro!th an !hich !oul lea to +ailure an colla-se o+ the #usiness"
In so$e situations, one investor $ay #elieve -assionately that one course o+
action !oul lea to certain iaster an the loss o+ the #usiness assets, !hile
another course o+ action $ay o++er gro!th +or the #usiness"
=o!ever, another investor $ay also #elieve -assionately that this situation
e3ists, ho!ever that the +irst course o+ action is the correct one, an that the
secon alternative !oul lea to isaster"
These is-utes $ay involve $ulti-le court cases an $ay e3ten over $any
years"
2.4.1. 4n(ivi(ual Enterprise
An iniviual enter-rise is controlle #y a single -erson"
This $ay range +ro$ a sole traer !ho o-erates on a #usiness #asis an
-er+or$s services -ersonally, to large co$-anies evelo-e an controlle
#y a single iniviual"
The iniviual enter-rise has the avantage o+ clear an consistent control"
7is-utes an struggles o not arise !ithin the control o+ the #usiness, !hich
can rain ti$e an energy +ro$ $anage$ent an evelo-$ent o+ the
#usiness"
Iniviual actions are not in con+lict, as they are eter$ine !ithin the
+ra$e!ork o+ a single vie!-oint"
131
A large -ro-ortion o+ success+ul #usiness are, or originally !ere, evelo-e
as iniviual enter-rises"
2.4.2. 3artners.ips
5ro+essional -artnershi-s, !here each -artner -er+or$s services -ersonally,
generally o-erate relatively s$oothly"
5artners $ay $eet several ti$es a year an vote on issues"
7i++erence $ay arise !ith actions such as e3-aning or issolving the
-artnershi-, ho!ever the -artnershi- agree$ent generally sets out the
ecision<$aking -rocess clearly"
2.4.3. Business partners.ips
5artnershi-s involving a traitional #usiness activity $ay o-erate s$oothly in
t!o -articular situations"
The +irst is !hen #oth -artners have al$ost ientical attitues an
a--roaches"
In any situation one -artner !oul $ost likely take e3actly the sa$e action as
the other -artner"
7is-utes an isagree$ents rarely arise, as #oth -artners think an o-erate in
a si$ilar !ay"
Another a--roach that is so$eti$es success+ul is !hen each -artner is
co$-letely i++erent"
2or e3a$-le, one -artner $ay -er+or$ the sales an $arketing, evelo-
contracts, an $ake arrange$ents !ith custo$ers an su--liers"
The other -artner $ay hanle the accounts an +inances o+ the #usiness,
$anage costs an arrange -rouction"
In this case, each -artner hanles a co$-letely se-arate -art o+ the -rocess"
136
This arrange$ent !oul re&uire that each -artner success+ully hanle their
section o+ the #usiness, ha con+ience in the other -artnerCs a#ility an !as
!illing to stay a!ay +ro$ the other -artnerCs +iel"
2.4.4. +o*operatives & group ontrol
So$e #usiness enter-rises are +or$e #y grou-s o+ -eo-le"
These $ay #egin !ith a strong enthusias$ an clear irection"
In so$e cases, co<o-eratives an enter-rises o-erate #y grou-s continue on
a long ter$ #asis"
=o!ever, in $any cases -ro#le$s arise"
As ti$e -rogresses, vie!s a#out +uture irections $ay gro! +urther a-art,
an $anage$ent an control o+ the enter-rise $ay loose irection as
isagree$ent an is-utes increase !ithin the grou-"
A+ter an initial success+ul -erio, isagree$ents $ay intensi+y, so$e
$e$#ers $ay leave the grou-, an eventually the enter-rise $ay #e
issolve"
Insurance co$-anies are in inustry in !hich co<o-erative societies
continue to o-erate +or long -erios"
Many insurance co$-anies #egan as co<o-erative societies, an eventually
gre! to #e $assive +inancial institutions"
2.4.5. 3rivate ompanies
In -rivate co$-anies, the #oar o+ irectors is generally co$-ose o+ the
$a9or shareholers in the co$-any"
In the case o+ -rivate co$-anies, this $ay range +ro$ t!o or three irectors,
u- to aroun a o@en #oar $e$#ers"
Iniviual irectors $ay or $ay not take -art in the ay<to<ay o-eration o+
the #usiness"
100
7ecisions are $ae #y iscussion, !ith $a9ority agree$ent #eing necessary
to carry a vote an result in an action #eing taken"

In so$e cases, a shareholer $ay #e a -assive investor an $ay have little
interest in the o-eration o+ the #usiness"
In other cases, several shareholers $ay have very strong vie!s an an
ongoing struggle $ay evelo- +or control o+ the co$-any"
In these cases, control $ay -ass +ro$ one -erson to another over ti$e, or in
so$e cases the #usiness $ay #e s-lit !ith one section o+ the #usiness
evelo-ing in a i++erent irection to the re$aining -arts o+ the #usiness"
2.4.!. 3ubli ompanies
5u#lic co$-anies generally have their shares liste on a stock e3change, an
the shares are generally s-rea a$ong a large nu$#er o+ investors"
7irectors are electe at an annual general $eeting an $ay #e $e$#ers o+
senior $anage$ent, senior $anagers +ro$ other co$-anies, retire chie+
e3ecutive o++icers, re-resentatives o+ $a9or shareholers an non<e3ecutive
irectors"
In these cases, the irectors generally have a su-ervisory role an are not
involve in the ay<to<ay $anage$ent o+ the co$-any, although several
senior $e$#ers o+ $anage$ent $ay also #e $e$#ers o+ the #oar"
7irection o+ the #usiness is generally controlle #y the chie+ e3ecutive
o++icer, !ith #oar authorisation #eing re&uire +or $a9or activities such as
#uying or selling a large -art o+ the #usiness"
The #oar generally $akes ecisions regaring $a9or events a++ecting the
structure o+ the co$-any, rather than its o-erations"
2or e3a$-le, takeover o++ers receive +ro$ other -arties are receive #y the
#oar, !hile #uying other co$-anies is usually initiate #y senior
$anage$ent"
/ontrol o+ -u#lic co$-anies generally o-erates s$oothly, although in so$e
cases a $a9or shareholer or s-ecial interest grou- $ay atte$-t to gain
several seats on the #oar, an +orce a $a9or action such as a $erger, e<
$erger, or other cor-orate restructure"
101
.#. Elements of a business
2.5.1. +as. flo5
/ash +lo! is the -ay$ents that are $ae an receive as -art o+ the ongoing
o-eration o+ a #usiness"
Retailing an services #usinesses o+ten o-erate in a high cash +lo!
environ$ent, !ith large volu$es o+ cash +lo!ing into an out o+ the
#usiness"
Ather #usinesses o-erate on a transaction #asis, !ith occasional large
transactions"
The $anu+acture o+ ca-ital e&ui-$ent is an e3a$-le o+ this"
,o! cash +lo! can occur !hen assets are hel !ithin #usiness structures #ut
are not utilise, such as assets -asse through inheritance, or !hen the
original #usiness o!ner has lost interest in o-erating the #usiness"
4et cash +lo! can #e strongly -ositive, strongly negative or #reak<even"
Strong -ositive cash +lo! can occur !hen a success+ul -rouct or service has
#een launche that $eets !ith a high e$an +ro$ custo$ers"
5ositive cash +lo! also occurs uring the -rouction -hase o+ a ne! -rouct,
+ollo!ing an initial evelo-$ent -hase"
4egative cash +lo! can occur uring the evelo-$ent -hase o+ a -rouct"
2or e3a$-le, the evelo-$ent o+ a ne! rug, or the construction o+ an oil
rilling -lat+or$ $ay #oth involve a large ca-ital cost over a -erio o+ ti$e"
7uring the evelo-$ent -hase, cash +lo! is strongly negative, !ith large
-ay$ents $ae #ut no inco$e receive"
A+ter co$-letion o+ the -ro9ect, ongoing -rouction costs $ay #e lo!, an
cash +lo! $ay #e strongly -ositive"
4egative cash +lo! also occurs uring ti$es o+ slo! sales, an in seasonal
#usinesses !here sales occur at -articular ti$es o+ the year"
102
2.5.2. +apital
/a-ital is a large #lock o+ $oney"
In a $ore general sense, ca-ital is a #lock o+ value"
2or e3a$-le, a $anu+acturing -lant $ay have a large ca-ital value, an coul
#e sol in orer to raise +uns +or a i++erent -ur-ose"
Capital re)uirements
Inustries vary !iely in their ca-ital re&uire$ents"
Service #usinesses generally have lo! ca-ital re&uire$ents"
2or e3a$-le, a +ir$ o+ architects $ay o-erate !ith lease e&ui-$ent an
o++ice s-ace, an the #usiness $ay have virtually no assets"
Mining an large scale $anu+acturing are ca-ital<intensive inustries, an
re&uire large a$ounts o+ ca-ital to esta#lish +acilities"
Sources of capital
In so$e cases, the #usiness o-erator $ay use -ersonal assets to +un the
ca-ital re&uire$ents o+ the #usiness"
In other cases, ca-ital is raise through e#t an e&uity"
7e#t involves #orro!ing +uns"
This $ay involve #ank loans, or issuing #ons an e#entures to investors"
7e#t oes not alter the o!nershi- or control o+ the #usiness"
%&uity is raise #y issuing shares, or #y raising aitional +uns +ro$
investors into a -artnershi- or trust"
()uit* capital
%&uity investors a ca-ital to the #usiness, an #eco$e -art o!ners o+ the
#usiness"
103
In the case o+ -artnershi-s, trusts an -rivate co$-anies, the ne! investors
an the -revious #usiness o!ners !oul each #eco$e -art<o!ners o+ the
e3-ane #usiness, in -ro-ortion to their shareholings or contri#ute assets"
In large -u#lic co$-anies ho!ever, this has little e++ect on the control o+ the
#usiness"
In these situations, the share o!nershi- is s-rea across a large nu$#er o+
investors"
A large -u#lic co$-any is generally $anage #y the chie+ e3ecutive, senior
$anage$ent an #oar o+ irectors"
$aising capital
Raising ca-ital, either through e#t or e&uity, results in the #usiness
#eco$ing a larger enter-rise"
This $ay #e one to +un the -urchase o+ another #usiness, +or e3a$-le, or
to +un the e3-ansion o+ e3isting o-erations"
Also, raising e&uity +uns is so$eti$es one !hen a #usiness is +acing
+inancial istress"
7e#t -ay$ents $ay #e high, cash +lo! $ay #e negative an cash resources
$ay #e lo!"
In this case, raising e&uity can #e use to re-ay e#t, restore the holings o+
cash to $anage ti$ing -ro#le$s !ith cash +lo!, an return the #usiness to a
+ir$ +ooting"
Control
In the case o+ -rivate co$-anies an iniviual enter-rises, raising e&uity can
have signi+icant i$-lications +or control o+ the #usiness"
In this case, the ne! investors $ay o!n a signi+icant -art o+ the #usiness,
!ith the e3isting shareholers o!ning a signi+icantly s$aller -art o+ the
#usiness"
100
In the case o+ -assive investors !ho o not !ish to -artici-ate in the
o-eration o+ the #usiness, this $ay not have a signi+icant i$-act on the
evelo-$ent o+ the #usiness"
In other cases, the ne! investors $ay !ish to e3ercise control, !hich $ay
result in is-utes regaring +uture irections, an change the #alance o+
control !ithin the $anage$ent o+ the #usiness"
2.5.3. -argins
A $argin is the -ercentage i++erence #et!een t!o nu$#ers"
2or e3a$-le, a #usiness $ay have inco$e o+ G10 an e3-enses o+ G6, leaving
a net inco$e o+ G1"
This !oul re-resent 10L o+ the inco$e o+ G10, an the gross o-erating
$argin !oul #e 10L"
So$e #usinesses o-erate !ith large cash in+lo!s an out+lo!s, !ith a s$all
$argin o+ i++erence"
Su-er$arkets an -etrol retailing are e3a$-les o+ lo!<$argin #usinesses"
These #usinesses o-erate !ith $argins o+ a +e! -ercent"
They are high volu$e, high cash +lo! #usinesses !ith lo! o-erating
$argins"
In other cases, the o--osite situation a--lies, an volu$es are lo! #ut
$argins are high"
=igh +ashion #outi&ues an lu3ury cars are e3a$-les o+ lo! volu$e, high
$argin #usinesses"
'olu$es an $argins generally $ove in o--osite irections, !ith high
volu$e #usinesses o-erating !ith lo! $argins, an lo! volu$e #usinesses
o-erating !ith high $argins"
A lo! $argin, lo! volu$e #usiness !oul eventually colla-se ue
insu++icient inco$e to $eet costs"
=igh $argin, high volu$e #usinesses generate a strong cash +lo! an -ro+it"
10*
7ue to co$-etitive +orces, this situation rarely -ersists +or an e3tene -erio
o+ ti$e"
.&. The three elements of a pro(uct
A -rouct $ay involve three istinct ele$entsB esign, $anu+acturing, an
#raning"
The esign -rocess involves creating the esign o+ the -rouct itsel+, together
!ith etails such as $anu+acturing $ethos, istri#ution -aths, -ricing an
-rouction volu$es"
Manu+acturing involves -roucing the actual ite$s +ro$ ra! $aterials"
In the case o+ services, this involves -er+or$ing the services +or the client"
Braning involves the #ran na$e that the -rouct is sol uner"
This $ay #e the na$e an logo o+ the #usiness itsel+, or a co$-letely
ine-enent #ran that is not relate to a -articular co$-any na$e or
#usiness structure"
A #usiness $ay -er+or$ 9ust one o+ the three +unctions, t!o +unctions, or the
co$-lete set o+ three +unctions +or a -articular -rouct"
A #usiness $ay also -er+or$ i++erent +unctions +or i++erent -roucts"
2or e3a$-le, a $anu+acturer $ay esign an -rouce -roucts uner its o!n
na$e, !hile also -er+or$ing contract $anu+acturing +or another #usinessCs
-roucts"
2.!.1. Design
The esign -rocess is a -ro9ect<#ase activity"
In so$e cases, a -rouct esign $ay involve a s$all -ro9ect or a continuous
-rocess over a -erio o+ ti$e"
In other cases, a esign $ay involve a large ca-ital e3-ense an involve
several yearsC evelo-$ent !ork"
10)
A -rouct esign is a +or$ o+ intangi#le -ro-erty"
A -rouct esign can #e license to e3ternal $anu+actures, or use +or
internal -rouction"
A esign -rocess involves a ca-ital cost to co$-lete the esign"
This $ay then #e +ollo!e #y an inco$e strea$ +ro$ -rouct sales or +ro$
licence +ees"
2.!.2. -anufaturing & #ervies
Manu+acturing involves the -rouction o+ ite$s +ro$ ra! $aterials"
5roucts are #ase on a esign, !hich $ay #e -rouce internally #y the
#usiness, or it $ay #e license +ro$ another #usiness"
Manu+acturing is a ca-ital<intensive activity, re&uiring e&ui-$ent, +acilities,
an stocks o+ ra! $aterials"
Manu+acturing is a continuous -rocess, !ith net inco$e #ase on the $argin
#et!een costs an out-ut -rices, less the +i3e costs o+ -rouction !hich are
s-rea across the -rouction volu$e"
Services involve -er+or$ing services +or a client"
This is generally a la#our<intensive activity"
4et inco$e is #ase on the i++erence #et!een +ees charge to clients an
sta++ costs, !ith the +i3e costs o+ the #usiness #eing s-rea across the
volu$e o+ services -er+or$e"
2.!.3. Bran(s
A #ran generally involves a na$e an gra-hical logos"
Bran na$es $ay re+er to a #usiness or other organisation, or they $ay #e
ine-enent o+ any -articular organisation"
Avertising an -ro$otion is #ase on #rans, together !ith s-eci+ic
-roucts that carry the #ran na$e"
108
Brans are o+ten a--lie to -roucts !ithin a -articular $arket"
2or e3a$-le, se-arate #rans $ay #e use +or #asic lo!<cost ite$s, an +or
$ore e3-ensive co$-le3 -roucts !ithin the sa$e general $arket"
.). Types of business
2.7.1. 3rimar$ pro(ution
5ri$ary -rouction inclues +ar$ing an $ining"
These inustries are ca-ital intensive, re&uiring large invest$ents in lan an
e&ui-$ent"
The out-ut -roucts o+ these inustries are co$$oities that trae in o-en
$arkets, !ith -rices that are highly volatile"
5rouction can also vary !iely, ue to !eather changes in +ar$ing, an ue
to changes in ore co$-osition in $ining"
+arming
2ar$ing inclues #roa<acre -rouction o+ !heat an grains, raising #ee+,
la$# an chickens, airy -roucts, !ool, $arket garens +or vegeta#les,
orchars +or +ruit, an !ine -rouction"
Although so$e +ar$ing co$-anies o e3ist, in $ost cases +ar$ing is carrie
out #y iniviuals or +a$ilies"
The #usiness an -ersonal assets are generally co$#ine an $ay e3ten
#ack $any generations"
2ar$ing is heavily in+luence #y govern$ent regulation"
Many countries have strict li$its +or agricultural i$-orts, or are co$-letely
close $arkets"
Su#siies an -rouction &uotas e3ist in $any countries, -articularly in the
Hnite States an %uro-e"
101
In so$e cases, the use o+ +or!ar sales an +utures contracts +or agricultural
-roucts can #e use to reuce the risks o+ volatile -rices"
In $any cases, ho!ever, e++icient -rouction an $anage$ent can #e carrie
out, #ut the +inal result is at the $ercy o+ the !eather an the $arket -rices
+or the -roucts"
/ining
Mines have a li$ite li+e s-an"
Mining inclues $ining +or #ulk co$$oities such as coal an iron ore,
-recious $etals such as gol, silver an -latinu$, ia$ons, an $ineral
sans"
The non<#ulk $ining inustry in Australia is co$-ose o+ t!o $a9or grou-s"
Several large $ining organisations o-erate a large nu$#er o+ $ines aroun
the !orl, an can trace their o-eration #ack a signi+icant -erio o+ ti$e"
These organisations use treasuries to $anage raising ca-ital, an use
+inancial $arkets instru$ents to reuce risks ue to -rice volatility in
co$$oity $arkets"
A nu$#er o+ s$all $ining co$-anies also e3ist"
In so$e cases these co$-anies o-erate a single $ine"
S$all $ining co$-anies are o+ten +or$e #y raising ca-ital, -urchasing a
nu$#er o+ $ine leases, an conucting geological surveys"
This ca-ital is o+ten consu$e &uite &uickly"
These co$-anies o+ten raise ca-ital on a regular #asis to continue o-erations,
or $ay #e issolve !ithin a -erio o+ years or even $onths"
=o!ever, the s$all e3-lorers can also rise shar-ly in -rice i+ they +in a
-ro$ising geological +or$ation"
Mine $anage$ent is a s-ecialise area"
This $ay involve evelo-ing a resource $a- that atte$-ts to ienti+y the
structure o+ the ore !ithin the groun, #ase on geological in+or$ation"
106
The co$-osition o+ the ore $ay vary ra$atically +ro$ -lace to -lace, an a
$ining -lan is evelo-e +ro$ the ore $a- to e3tract the ore in the $ost
e++ective !ay"
Managing $ining involves scheuling -rouction an $aintenance, an
altering the $ining -attern an -lan as the ore #oy is graually e3-ose"
5rices +or -recious $etals are highly volatile"
In so$e cases $ines are close +or a -erio o+ ti$e !hen -rices are lo!, an
are re<o-ene !hen -rices are higher"
Bulk $ining is &uite i++erent to $ining +or -recious $etals, ia$ons an
other rare $inerals"
Bulk $ining involves coal, iron ore, #au3ite +or alu$iniu$ an other #ulk
co$$oities"
Mining #ulk co$$oities generally involves e3tracting a continuous #oy o+
the co$$oity"
5rouction can #e varie at !ill, an the result o+ the -rouction is a
reasona#ly constant out-ut o+ the co$$oity"
Bulk co$$oities are not trae in o-en $arkets, #ut are elivere into long<
ter$ contracts !ith custo$ers"
2or e3a$-le, coal is use in -o!er generation, an iron ore is elivere to
steel $ills"
5rices are set #y negotiation !ith #uyers, a -rocess that can take $onths"
7ue to the +act that there are a s$all nu$#er o+ glo#al su--liers an
custo$ers, negotiations are co$-le3 an intense, an the negotiating -o!er
o+ the -arties has a $a9or i$-act on -rices an -ro+ita#ility"
2.7.2. #ervie businesses
Service #usinesses charge +ees +or -er+or$ing services, rather than +or
-roucing an su--lying -roucts"
+ees
1*0
2ees are charge in a variety o+ !ays"
This can inclue so$e o+ the +ollo!ing arrange$entsE
A ti$e<#ase +ee such as an hourly rate"
A +ee +or a -articular service"
A regular +ee +or an on<going arrange$ent"
A usage<#ase +ee relate to usage o+ the service"
A -ercentage +ee #ase on a transaction si@e"
2or e3a$-le, a contract a$inistration service $ay charge a +ee -er
transaction, !hile an auction service $ay charge a -ercentage o+ the sale
-rice as a +ee"
Capital
Service #usinesses generally have lo! ca-ital re&uire$ents"
%&ui-$ent an o++ice s-ace is o+ten lease"
Costs
Services #usiness are generally la#our<intensive"
Salaries an other -ay$ents to e$-loyees are o+ten the $a9or cost, !ith the
i++erence #et!een inco$e an sta++ costs #eing the net inco$e o+ the
#usiness"
%&ui-$ent an ra! $aterial re&uire$ents are generally lo!, !ith rental +or
o++ice s-ace, co$-uter services an utilities #eing other $a9or costs"
+inancial & operating structure
Service #usinesses are cash +lo! #ase #usinesses, rather than asset<#ase
#usinesses such as $anu+acturing"
1*1
A service #usiness generally has +le3i#ility to change o-erations to $eet
changes in e$an +or services +ro$ clients"
Service #usinesses generally have a high -ro-ortion o+ varia#le costs, rather
than +i3e costs such as e&ui-$ent an +acilities"
This results in net -ro+it varying graually as the si@e o+ the #usiness rises or
+alls"
In contrast, #usinesses !ith a high -ro-ortion o+ +i3e costs, such as
$anu+acturing, $ay have losses !hen volu$es are lo!, an -ro+it rises as
volu$es increase"
Pro"lems
A $a9or -ro#le$ that can evelo- !ith service #usinesses relates to hiring
sta++ an creating a structure !here a large -ro-ortion o+ the !ork that is
-er+or$e oes not relate to the services that receive inco$e +ro$ clients"
2or e3a$-le, a large research an -rouct evelo-$ent area $ay #e
esta#lishe"
Although this $ay #e necessary +or the long ter$ survival an gro!th o+ the
co$-any, this coul also #e a signi+icant rain on the cash +lo! o+ the
#usiness"
This situation can also arise in $ore su#tle !ays"
2or e3a$-le, a contract a$inistration #usiness $ay e$-loy sta++ +or ata
entry, co$-uter services, sales an $arketing, su-ervision an $anage$ent,
hu$an resources, cor-orate strategy an -lanning, risk assess$ent an
isaster recovery -lanning an a !ie range o+ other areas"
In these cases, a situation can arise !here total sta++ nu$#ers an costs
cannot #e su--orte #y the inco$e that is receive +ro$ services su--lie to
clients"
This issue is -art o+ the general $anage$ent an o-eration o+ a #usiness,
ho!ever it $ay #e a -articular issue !ithin service #usinesses"
1peration
Service #usinesses are relatively si$-le to esta#lish an o-erate"
1*2
In $ost cases a service #usiness can #e esta#lishe !ith a s$all initial si@e,
!hich $ay gro! !ith increasing e$an +or services +ro$ clients"
2.7.3. 3ro%et (evelopment
5ro9ect evelo-$ent #usinesses involve the construction or evelo-$ent o+
large ite$s over an e3tene -erio o+ ti$e"
This inclues -ro-erty evelo-$ent, $eical rug evelo-$ent, +il$
-rouction, an co$-uter so+t!are evelo-$ent"
These #usinesses re&uire a large su$ o+ ca-ital to $eet the costs o+
evelo-$ent #e+ore inco$e is receive"
In so$e cases the inco$e +ro$ the -ro9ect $ay #e receive as a sale -rice
!hen the -ro9ect is co$-lete"
In other cases, the #usiness retains o!nershi- o+ the +inishe -rouct, an
then licenses or -rouces the -rouct over an e3tene -erio o+ ti$e"
5ro9ect $anage$ent is a key ele$ent o+ these #usinesses"
In so$e cases the -ro9ects $ay e3ten over several years, !ith large su$s o+
$oney an $any co$-le3 tasks #eing involve in co$-leting the -ro9ect"
5oor -ro9ect $anage$ent can lea to large increases in costs over #uget,
long elays as so$e tasks cannot #e -er+or$e until other tasks have #een
co$-lete in se&uence, an the -ro9ect never #eing +ully co$-lete"
In so$e cases -ro9ects are a#anone a+ter consiera#le ti$e an cost has
#een incurre"
This can ha--en ue to -oor -ro9ect $anage$ent, ue to the original conce-t
an esign o+ the -ro9ect #eing i$-ractical, or ue to une3-ecte events
occurring a+ter the -ro9ect has co$$ence"
2inancing is another $a9or ele$ent o+ -ro9ect evelo-$ent"
5ro9ect evelo-$ent $ay involve a strong negative cash +lo! +or an e3tene
-erio o+ ti$e, +ollo!e #y various revenue -ay$ents"
1*3
Inco$e $ay a--ear at i++erent ti$es in stages, it $ay occur as a lu$- su$
on -ro9ect co$-letion, or it $ay #e a long<ter$ regular inco$e to the
#usiness"
The revenues +ro$ the -ro9ect $ay #e a +i3e value, or they $ay #e
unkno!n, ue to an unkno!n e$an +or the +inal -rouct"
5ro9ect evelo-$ent occurs on a s$aller scale !ithin $any #usiness
o-erations"
The sa$e stages $ay #e involve, although the -ro9ect itsel+ $ay #e a s$all
-art o+ the #usiness o-eration, rather than the -ri$ary task -er+or$e #y the
#usiness"
2.7.4. Distribution
7istri#ution as a #usiness involves trans+erring goos +ro$ one -lace to
another, or +ro$ one -arty to another +or sale"
This inclues retail o-erations, i$-orters, an su--lying the -roucts o+
another #usiness to e3isting custo$ers"
7istri#ution is a cash +lo! #usiness"
7istri#ution has relatively lo! ca-ital re&uire$ents, although a certain
a$ount o+ ca-ital $ay #e involve in carrying stock"
7istri#ution #usinesses are relatively si$-le to esta#lish, an istri#ution is a
highly co$-etitive #usiness"
Retail #usinesses generally o-erate !ith lo! $argins, !hich are as lo! as a
+e! -ercent in the case o+ su-er$arkets"
Dithin istri#ution #usinesses, cost control, stock $anage$ent an the
choice o+ stock to carry are signi+icant +actors"
2.7.5. 'sset*base( servie businesses
Asset<#ase service #usinesses involve -roviing services #ase on a large
ca-ital asset"
1*0
This inclues In+rastructure assets such as toll roas an air-orts"
This ty-e o+ #usiness also inclues large ca-ital e&ui-$ent that is use to
-rovie services, such as so$e $eical e&ui-$ent"
In these situations, a large ca-ital invest$ent is re&uire to -urchase the
asset"
This !oul usually #e source +ro$ +uns raise +ro$ leners an investors,
rather than -ersonal assets"
2ollo!ing the large initial cost, a long series o+ regular an sta#le -ay$ents
$ay +ollo!"
This $ay involve tolls +ro$ a toll roa, or -ay$ents +or the use o+ the asset"
A solariu$ is another e3a$-le o+ this ty-e o+ #usinesses"
A solariu$ -urchases the e&ui-$ent, an then receives regular inco$e +ro$
the clients +or the use o+ the e&ui-$ent"

Although so$e $inor $aintenance an other tasks $ay #e involve, an
in+rastructure asset is largely a +inancial transaction"
Ance the initial invest$ent is $ae, there $ay #e very +e! ongoing costs"
'aluing a #usiness o+ this ty-e $ay involve co$-aring the +uture inco$e
strea$ to the initial ca-ital cost, using a calculation such as a net<-resent<
value calculation
2.7.!. #mall sale manufaturing
Manu+acturing involves -roucing -hysical ite$s +ro$ ra! $aterials"
S$all scale $anu+acturing inclues a range o+ #usinesses that -rouce ite$s
+or sale"
In $any cases these $ay #e la#our<intensive inustries, !ith $uch o+ the
!ork #eing -er+or$e #y han"
Businesses o+ this ty-e are relatively si$-le to esta#lish"
1**
Issues !ithin these #usinesses inclue +ining custo$ers, an evelo-ing
sustaina#le $arkets +or the +inishe -rouct"
Manage$ent o+ these #usinesses $ay also #e $ore co$-le3 than service
#usinesses"
Manu+acturing involves sourcing ra! $aterials +ro$ su--liers, $anaging
levels o+ stock, -roucing the actual goos an -urchasing e&ui-$ent as
necessary"
S$all scale $anu+acturing #usinesses $ay continue to o-erate +or long
-erios o+ ti$e"
In other cases, they $ay cease to o-erate ue to lack o+ interest in continuing
the o-eration, or e3cessive i++icult in +ining ne! custo$ers"
In other cases, a strong e$an +or the -rouct $ay a--ear, an the #usiness
$ay e3-an in si@e"
This !oul generally involve -urchasing e&ui-$ent ena#le larger volu$es o+
goos to #e -rouce"
As this -rocess continues, the cost -er unit graually +alls"
=o!ever, the ca-ital re&uire$ents o+ the #usiness also increase" This $ay
involve taking out loans to -urchase e&ui-$ent, or raising invest$ent +uns
to ena#le the #usiness to e3-an"
2.7.7. 8arge sale manufaturing
,arge scale $anu+acturing is a ca-ital<intensive #usiness"
This inclues the -rouction o+ cars an other vehicles, che$ical -rouction,
-a-er $ills an so +orth"
Ma9or e3-enses in these cases inclue the ra! $aterials o+ -rouction,
$aintenance costs, an the e-reciation o+ the ca-ital e&ui-$ent"
Manu+acturing on a large scale generally involves -roucing co$$oity
ite$s"
/o$$oity ite$s a--ear in large volu$es, !ith -rices set #y $arket +orces"
1*)
5rices +all to the lo!est sustaina#le level in o-en $arkets !ith lo! #arriers to
entry"
Many $anu+actures o-erate !ith lo! $argins, an !ith a lo! return on
assets"
Managing $anu+acturing -rouction is a s-ecialise area"
Issues inclue ca-acity utilisation, age an e++iciency o+ e&ui-$ent, +ault
rates in -rouction, scheuling -rouction, inventory $anage$ent an
sourcing ra! $aterials"
/a-acity utilisation relates to the -rouction +ro$ the +acility"
The -rouction generate uring a -erio, as a -ercentage o+ the ca-acity o+
the +acility, has a signi+icant i$-act on the -ro+it or loss o+ the o-eration"
Issues causing lo! -rouction out-ut $ay inclueE
A lack o+ e$an +ro$ custo$ers"
5oor -rouction $anage$ent an scheuling"
Autate e&ui-$ent
Inventory levels #eing too lo!, causing #reaks in -rouction"
2ault rates are a $a9or -rouction issue, an reucing +ault rates through
resigning e&ui-$ent an changing -rouction -rocesses $ay have a
signi+icant i$-act on -rouction e++iciency"
Ra! $aterials are a $a9or cost o+ $anu+acturing"
A reuction in ra! $aterial costs through using alternative su--liers, larger
volu$es, alternative $aterials an so +orth $ay increase $argins"
2.7.8. 3ooling Businesses
Banking an insurance are e3a$-les o+ -ooling #usinesses that involve
co$#ining a large nu$#er o+ iniviual ite$s"
1*8
In the conte3t o+ #anking, a large nu$#er o+ e-osits o+ various si@es an
ter$s are co$#ine !ith a large nu$#er o+ loans o+ various si@es an ter$s"
This -rocess has t!o $a9or #ene+its"
A e+ault on a loan +ro$ an iniviual custo$er oes not have a signi+icant
i$-act on any iniviual custo$er"
In the case o+ a irect loan +ro$ one -arty to another, a e+ault on the loan
$ay result in the entire ca-ital #eing lost"
A s$all -ercentage o+ #ank loans are not +ully recovere"
These a$ounts are an e3-ense o+ the o-eration"
ShareholerCs ca-ital is retaine !ithin the #alance sheet as a #u++er against
#a e#ts"
The secon #ene+it o+ #anking is that it #reaks the link #et!een the #orro!er
an the lener"
This allo!s #orro!ers an leners to transact in various si@es an ter$s"
2or e3a$-le, $any resiential $ortgages have a ter$ o+ 2* years, #ut very
+e! e-osits have a ter$ o+ this length"
Also, +uns can #e e-osite or !ithra!n !ithout the nee to have another
-arty !ho is -re-are to $eet the o--osite sie o+ the transaction"
In the case o+ insurance, the risks o+ a large nu$#er o+ -olicy holers are
co$#ine into a single -ool"
2uns are then set asie to $eet the average level o+ clai$s"
This -rovies a +acility that allo!s a custo$er to $ake a s$all +i3e
-ay$ent, in e3change +or eli$inating the -ossi#ility o+ +acing a large
iniviual loss"
Transaction #anking, !hich involves the aily -rocess o+ che&ues, e-osits
an trans+ers, is a &uite se-arate #usiness +ro$ the loan an $a9or e-osit
o-erations o+ #anking"
Transaction #anking is a service #usiness"
5ooling #usiness re&uire a $ini$u$ si@e in orer to o-erate"
1*1
It is not generally -ossi#le to o-erate a very s$all -ooling +un, such as an
e3tre$ely s$all #ank or insurance co$-any, as an iniviual transaction
coul have too large an i$-act on the entire +uns"
This $ini$u$ si@e issue results in the +act that ne! #anks an insurance
co$-anies are create vary rarely, an are o+ten esta#lishe #y e3isting
associations or #usinesses, rather than as iniviual enter-rises"
Although there have #een $any $ergers, cor-orate changes an changes in
na$e, $any #anks an insurance co$-anies !ithin Australia can trace their
history #ack to the earliest ays o+ settle$ent"
2.7.9. -ar6eting Organisations
Marketing organisations source -roucts, hol #ran na$es, an organise
avertising an istri#ution"
Businesses using this $oel o not -er+or$ -rouction internally, #ut use
e3ternal services an contract $anu+acturing to -rouce the -roucts or
-er+or$ the services"
So$e large #usinesses are e++ectively $arketing organisations rather than
$anu+acturers or service -roviers"
These #usinesses usually have lo! ca-ital re&uire$ents, !ith a s$all nu$#er
o+ sta++ involve in -rouct esign, $anaging e3ternal su--liers an
-ro$oting the #ran na$es"
Arganisations o+ this ty-e have a s$all nu$#er o+ internal o-erations,
ho!ever large cash +lo!s $ay +lo! through the #usiness, an large asset
values $ay #e involve"
Marketing organisations rely heavily on istri#ution an $aintaining the
-ro+ile o+ #ran na$es"
This are i$-ortant issues in all #usiness o-erations, ho!ever there $ay #e
li$its to the gro!th that can #e achieve si$-ly through #ran -ro$otion"
2.7.1". Design an( artisti 5or6s businesses
1*6
/reating esigns an artistic !orks involves a range o+ #usinesses incluing
avertising, architectural esigns, co$-uter so+t!are, $usic, an +il$
-rouction"
So$e o+ these #usinesses also +all into the category o+ -ro9ect evelo-$ent
#usinesses, or service #usinesses"
Aut-ut $ay #e -rouce +or a s-eci+ic client or event"
In other cases, o!nershi- o+ the -ro-erty is retaine, an use o+ the esign or
the !ork is licence to custo$ers"
In $ost cases these #usinesses are la#our<intensive !ith +e! +i3e ca-ital
re&uire$ents"
=o!ever, ca-ital $ay #e re&uire to +un e3-enses uring long -ro9ects"
Also, so$e engineering evelo-$ents re&uire signi+icant ca-ital +or
co$-uter resources an testing +acilities"
Issues !ith #usinesses o+ this ty-e inclue the +act that inco$e can #e highly
unsta#le an volatile, ue to the success or +ailure o+ i++erent esigns or
create ite$s"
2.7.11. #ummar$ of business t$pes
Business Type Activity Funding basis Process Income
6anufacturing Producing
ph"sical items
Asset 0ased Continuous Sales
Ser4ices Performing
commercial
ser4ices
Cash flo+
0ased
Continuous Client fees
Designs artistic
+or7s
Creating designs
a0stract items
Capital 0ased Pro8ect 0ased Licence fees
Construction Constructing
ph"sical items
Cash flo+ or
capital 0ased
Pro8ect 0ased Sales or contract
fees
1)0
2.7.12. #ome in(ustries an( businesses
The +ollo!ing ta#le lists so$e co$$on inustries an #usinesses"
The categories are #ase on the nature o+ the #usiness, an the list coul also
#e #roken u- #y other criteria, such as cash +lo! #usinesses vs" asset<#ase
#usinesses"
So$e inustries cross over several categories, an in other cases, an
iniviual #usiness $ay #e &uite #i@arre in structure an o-eration, an $ay
e+y categorisation co$-letely"
5ri$ary -rouction
2ar$ing Broa<acre (!heatJgrains), #ee+, la$# .
chicken, +ruit . vegeta#les, airy, !ool,
!ine
Mining Bulk $ining (coal, iron ore), -recious
$etals (gol, silver, -latinu$), ia$ons,
oil . gas
Re+ining 2uel, steel, alu$iniu$, che$icals
Services
5ro+essional ,egal, accounting, architectural,
invest$ent $anage$ent, engineering
Trae Machinery $aintenance, utilities,
resiential construction, -ainting,
lansca-ing
7o$estic /leaning, ho$e $aintenance, chilcare
5ersonal =airressing, #eauty services
Trans-ort Roa, rail, shi--ing, travel agencies
1)1
=ealthcare Meical, surgical, nursing, ental,
vetenary, hos-itals
2inancial Transaction #anking, invest$ent
$anage$ent, +inancial avisory, valuing,
stock #roking, stock e3changes, +utures
e3changes, auction houses
Inustrial /ontract $ining, co$$ercial
construction
Business Secretarial, contract a$inistration,
-ro-erty services
=os-itality Restaurants, hotels, $otels, +unction
$anage$ent
%ntertain$ent /ine$as, stage -rouctions, +il$
-rouction
%ucation %uction elivery
5ro9ect evelo-$ent 7rug evelo-$ent, co$-uter so+t!are,
-ro-erty evelo-$ent, construction
7esigns . artistic !orks 2il$ -rouction, $usic, architectural
esigns, co$-uter so+t!are, -hysical
-rouct esigns, contract engineering
7istri#ution Retailing, i$-orting, cine$a, thir<-arty
istri#ution
Asset<#ase services In+rastructure (roas, air-orts), large
$eical e&ui-$ent, solariu$s,
gy$nasiu$s
Manu+acturing /ra+ts, han<$ae -roucts, cars .
trucks, general $anu+acturing, e&ui-$ent
1)2
$anu+acturing, e+ence e&ui-$ent,
#akeries, +oo . #everages
Inustrial co$$oities 5a-er, steel, che$icals, !ire, -i-ing
5ooling #usinesses Banking (loansJe-osits), insurance,
casinos
1)3
.-. *is+
2.8.1. ,is6 in business
A-erating a #usiness enter-rise is a risky activity"
/ash +lo!s $ay rise an +all"
There $ay #e -erios o+ healthy -ro+its, an other -erios o+ losses"
Investing in -ro9ects is also risky, !ith the costs usually -ai in avance, an
an uncertain result !hen the -ro9ect is +inishe"
Also, s-eci+ic events $ay occur that coul cause a negative i$-act on the
#usiness, ranging +ro$ a +ire in a #uiling, to a shar- rise in the -rice o+ ra!
$aterials"
Risk $anage$ent is an i$-ortant issue in the e++ective o-eration an
evelo-$ent o+ a #usiness"
2.8.2. ,is6 management
Risk $anage$ent involves $anaging ongoing risks !ithin #usiness
o-erations, such as volatile -rices, an -re-aring +or events that $ay have a
etri$ental e++ect on the #usiness"
Risks that +or$ -art o+ the o-eration o+ a #usiness $ay inclue volatile -rices
an irregular volu$es o+ trae"
S-eci+ic events $ay range +ro$ +ire !ithin a #uiling, to the cancellation o+ a
$a9or custo$er orer, or #eing sue #y another -arty"
Risk $anage$ent involves so$e o+ the +ollo!ing issuesE
Managing on<going risks such as volatile -rices"
/onsiering the -ossi#le +uture events that coul occur"
Taking ste-s to reucing the chance that a negative event $ay occur"
1)0
Taking ste-s to reuce the i$-act on the #usiness i+ an event i
occur"
Structuring the #usiness in a +le3i#le !ay that !oul allo! it to
aa-t to une3-ecte events"
/are shoul #e taken !ith consiering an -re-aring +or +uture events, as a
+alse sense o+ security can #e create !hen this is one"
In reality, the events that actually occur are usually things that !ere not even
thought o+"
=o!ever, -re-aring +or o#vious -ossi#ilities, such as +ire, an structuring the
#usiness in a generally +le3i#le !ay $ay reuce the a$age to the #usiness
uner a range o+ i++erent +uture conitions"
2.8.3. 1eneral ris6 issues
Prevention
5reventing a -ro#le$ +ro$ occurring in the +irst -lace is greatly -re+era#le to
ealing !ith the -ro#le$ a+ter it has alreay occurre"
This $ay reuce costs, ti$e elays, isru-ting to the regular #usiness
o-erations, an a !ie range o+ other -ro#le$s"
-iming of pa*ments
In so$e cases, +inancial losses can #e recovere +ro$ either insurance or
legal action"
=o!ever, long elays $ay #e involve in #oth cases"
The +inancial a$ounts eventually recovere o not generally co$-ensate +or
i$-act on the #usiness o+ the event actually occurring"
%ven !hen insurance an soun legal contracts are in -lace to re+un any
cash losses, ste-s shoul still #e taken to -revent the events +ro$ occurring
!herever -ossi#le"
1)*
Preparation
Most risk $anage$ent techni&ues nee to #e -ut in -lace #e+ore the event
occurs, rather than a+ter it occurs"
This ranges +ro$ #acku- generators an insurance -olicies, through to the
!ay that the #usiness is structure an o-erate"
Dhile consieration o+ risk $anage$ent issues is i$-ortant, action is
-articularly i$-ortant in this area o+ #usiness, as ste-s cannot usually #e
taken once the event has alreay occurre"
Creation & Destruction
/reation an estruction are not sy$$etrical"
7estruction can occur slo!ly over a long -erio o+ ti$e, or it can #e
e3tre$ely ra-i"
/reation, in contrast, $ay #e a slo! -rocess an can only occur continuously
over a -erio o+ ti$e"
2or e3a$-le, a #uiling coul ecay slo!ly over a -erio o+ ti$e, or it coul
#e estroye in a $o$ent #y +ire or e3-losion"
=o!ever, a #uiling cannot #e constructe in a $o$ent"
It can only #e constructe over a -erio o+ ti$e"
In a si$ilar !ay, a #usiness o-eration is evelo-e over a -erio o+ ti$e"
=o!ever, a #usiness can #e estroye in a single ay, #y a +ire through a
$a9or +acility, a court orer +ro$ a legal action, or the cancellation o+ an
arrange$ent !here a single custo$er or su--lier is involve"
This issue highlights the i$-ortance o+ risk $anage$ent !ithin #usiness"
7evelo-ing a #usiness over the long ter$ involves t!o actions"
The +irst is the e++ective o-eration an evelo-$ent o+ the #usiness, !hile the
secon is taking ste-s to -revent $a9or a$age to the #usiness +ro$ a single
event or situation occurring"
1))
(%cessive risk management
In so$e cases, e3cessive resources are evote to the issue o+ risk
$anage$ent"
%3-ensive #acku- +acilities $ay #e #uilt to cater +or events that ha--en
rarely, an !here a -ractical solution to the -ro#le$ coul #e eter$ine at
the ti$e !ithout a great eal o+ i++iculty"
In larger organisations, co$-le3 -roceures an etaile -lans $ay #e
evelo-e, an entire tea$s $ay generate large volu$es o+ ocu$entation
relating to risk $anage$ent issues"
Risk $anage$ent oes not nee to involve a large a$ount o+ ti$e, cost, or
co$-le3ity"
=o!ever, a range o+ si$-le ste-s $ay -rove at a later ate to have save the
#usiness +ro$ $a9or a$age"
-aking risks
Business itsel+ involves taking consiera#le risk"
In general, there is no -ossi#ility o+ a signi+icant -ositive return, !ithout also
acce-ting a -ossi#ility o+ a signi+icant negative return"
/osts +or e&ui-$ent, +acilities, an -ro9ects such as -rouct evelo-$ent
$ust generally #e -ai in avance, #ut the inco$e +ro$ the activity !ill not
#e kno!n until so$e ti$e in the +uture"
This is the nature o+ #usiness an invest$ent"
=o!ever, there are also other issues that can #e consiere" These inclueE
Avoiing taking unnecessary risks"
Avoiing risks that are not central to the o-eration o+ the #usiness
activity, such as +ire risk !ith #uilings"
Structuring the #usiness to avoi unnecessary a$age !hen changes
or events occur"
1)8
2.8.4. #peifi ris6s
2.8.4.1. 3rie ,is6
5rice risk involves the risk that a #usiness +aces ue to changes in -rices"
In so$e inustries, this is not a $a9or concern"
In service inustries, +or e3a$-le, -rices $ay #e sta#le +or #oth costs an the
+ees charge +or services"
In ter$s o+ -roucts, coal is an e3a$-le o+ a co$$oity that is sol through
long ter$ +i3e -rice contracts !ith custo$ers, !ith regular scheule
$onthly -rouction"
In so$e inustries, ho!ever, -rice volatility is a $a9or issue"
In-ut costs can #e either sta#le or volatile, !hile the -rices +or the +inishe
-roucts can also #e sta#le or volatile"
The +ollo!ing ta#le lists so$e co$#inations, e3a$-les o+ inustries, an
ste-s that can #e taken to reuce the -rice risk"
Costs Prices (%amples
Sta#le Sta#le Service #usinesses
'olatile Sta#le Airlines (+uel -rices)
Sta#le 'olatile Agriculture, Mining
'olatile 'olatile (set
#y $arket)
5etrol re+ining
'olatile 'olatile (set
#y #usiness)
Knitte gar$ents (!ool . cotton
-rices)
1)1
'olatile out-ut -rices +all into t!o categories"
In the case o+ -rices set #y $arket +orces, the #usiness cannot control these
-rices"
In the -etrol re+ining e3a$-le, #oth the in-ut an out-ut -rices are volatile
-rices set #y $arket +orces, an this leas to the #usiness $argin an -ro+it
also #eing highly volatile"
In other cases, the #usiness can set the out-ut -rice to -ass the changes in
in-uts through to the custo$er"
In the knitte gar$ents e3a$-le, the -rice o+ !ool is a volatile value, !ith
the -rice o+ the !ool #eing inclue in the +inal -rice o+ the gar$ent"
Methos o+ controlling -rice risk inclue the +ollo!ingE
Matching the ter$ o+ long<ter$ custo$er agree$ents at +i3e -rices
!ith e&uivalent +i3e<-rice su--ly agree$ents"
Maintaining a #u++er o+ !orking ca-ital to s$ooth cash +lo!s, !ith
the average o+ the in-ut -rices eter$ining the out-ut -rice"
5assing changes in in-ut -rices through to the -rice o+ the +inishe
-rouct"
Hsing +inancial $arkets instru$ents such as +utures contracts to set
+uture -rices an reuce volatility"
Maintaining a large inventory, #uying !hen -rices are lo! an
using e3isting stocks !hen -rices are high"
2.8.4.2. /oreign e).ange ris6
2oreign e3change risk is a +or$ o+ -rice risk"
The e3change rate #et!een currencies can #e highly volatile, !ith rises or
+alls o+ 10L !ithin a +e! !eeks #eing a co$$on occurrence"
1)6
Ra! $aterials that are i$-orte $ay result in volatile costs, !hile the
inco$e receive +ro$ e3-ort sales $ay also #e volatile"
Methos o+ controlling +oreign e3change risk inclue the +ollo!ingE
Hsing +inancial $arket instru$ents such as +utures contracts to
hege the risk o+ s-eci+ic -ay$ents"
Sourcing ra! $aterials +ro$ a si$ilar region, or in the sa$e
currency, as the location o+ e3-ort sales"
Maintaining a #u++er o+ ca-ital to s$ooth the cash +lo!s +ro$
e3-enses +or i$-orte $aterials, an inco$e +ro$ e3-orts"

Altering the -rices o+ +inishe goos !hen a sustaine increase or
ecrease in an e3change rate occurs"
Su--lying e3-orte goos at a +i3e local currency -rice, !ith the
rise or +all in e3change rates #eing #orne #y the custo$er" This is
the usual -ractice !hen goos are orere irectly +ro$ an overseas
su--lier, rather than through a local istri#utor" This is the source o+
+oreign e3change risk !hen the #usiness itsel+ orers goos +ro$
other su--liers"
Assets hel in overseas countries, an e#t raise in +oreign currencies, #oth
change value in local currency ter$s !ith changes in the e3change rate"
2or e3a$-le, a #usiness $ay o!n a storage !arehouse in a +oreign country"
The value o+ assets that are hel in overseas countries $ay #e hege #y
raising e#t in the sa$e currency"
The e#t coul #e use to -urchase the asset, or it coul #e converte to the
local currency an -lace on e-osit"
2.8.4.3. :olume ris6
So$e #usinesses o-erate !ith a steay volu$e o+ sales, !hile others have
seasonal, cyclical or rano$ changes in sales"
Seasonal inustries such as -ri$ary -rouction an so$e retail o-erations
have the $a9ority o+ their sales at certain ti$es o+ the year"
180
/yclical inustries such as resiential construction -ass through regular
-erios o+ high activity +ollo!e #y -erios o+ lo! activity"
Rano$ sales occur in so$e inustries, such as +il$ an $usic -rouction,
!here sales are highly volatile +ro$ -erio to -erio ue to the success or
+ailure o+ iniviual -ro9ects"
So$e -ossi#ilities to reuce the i$-act o+ these changes inclueE
Maintaining a #u++er o+ ca-ital, ra!ing o!n +ro$ the ca-ital in
slo! -erios an re-lenishing it uring -erios o+ high sales"
A-erating i++erent activities to allo! continue sales uring slo!
-erios" 2or e3a$-le, a retail outlet $ay sell sno! skiing e&ui-$ent
uring !inter, an !aterskiing e&ui-$ent uring su$$er"
Altering #illing -ractices to s$ooth cash +lo!" 2or e3a$-le, this
coul involve regular -rogress -ay$ents through a -ro9ect, or #illing
e3-enses irectly to a client"
Dhere -ossi#le, using +acilities an services that can #e -urchase
as neee, rather than o!ning assets an esta#lishing -er$anent
+acilities
2.8.4.4. /rau( & mismanagement ris6
2rau an $is$anage$ent risk involves the risk that a$age !ill occur to
the #usiness ue to the actions o+ an e$-loyee"
This $ay involve a !ie range o+ activities, such as so$e o+ the +ollo!ingE
7irectly !ithra!ing +uns +ro$ accounts o+ the #usiness"
5urchasing goos or services +ro$ su--liers that are associate
!ith the e$-loyee at high -rices"
Acce-ting -ay$ents +ro$ outsie -arties to -er+or$ actions that
#ene+it the outsie -arty at the e3-ense o+ the #usiness"
181
In -ractice, the greatest risk involves a situation !here the e$-loyee
generates a -u#lic a--earance o+ a situation that i++ers +ro$ the actual
reality"
This involves a se-aration occurring #et!een the -resente situation an the
actual situation"
This $ay involve -resenting +alse in+or$ation such as +inancial results an
current holings"
This $ay #e one #y a chie+ e3ecutive o-erating an entire #usiness, #y a
traer o-erating a traing -ort+olio, or #y so$e other e$-loyee"
Aver ti$e, the re-orts an +inancial state$ents $ay #eco$e +urther an
+urther +ro$ the actual situation, until a co$-any that a--eare to #e
o-erating nor$al suenly #eco$es insolvent, !ith large e#ts an a
colla-se o+ the #usiness"
This situation has occurre in a nu$#er o+ cases, leaing to a colla-se an
li&uiation o+ several large organisations"
This risk can #e reuce in so$e o+ the +ollo!ing !aysE
%nsuring that regular re-orting is etaile an u-<to<ate"
Re-orts that are very late an contain li$ite etails $ay #e a sign
o+ -otential -ro#le$s" This also a--lies to general $anage$ent o+
the #usiness, as !ell as eli#erate +alsi+ication"
Maintaining an internal auit e-art$ent that re-orts irectly to the
#oar o+ irectors or the #usiness o!ners"
This auit e-art$ent shoul have authority to ins-ect all
ocu$ents an recors, an re&uests to ins-ect in+or$ation #y this
area !oul overrie instructions +ro$ all other e$-loyees, incluing
the chie+ e3ecutive"
%nsuring that e3ternal auits o+ accounts -rocee on the stanar
#asis, that auit re-orts are receive irectly #y the #oar, an that
action is taken to aress serious -ro#le$s that are raise in auit
re-orts"
182
Maintaining an internal traing risk assess$ent area that is
ine-enent o+ the traing activities, an auits the risk e3-osure o+
traing -ort+olios on an ar$Cs length #asis"
Auiting settle$ent areas to etect -ro#le$s such as +alse accounts,
an accounts use to hol loss<$aking -ositions that are not
inclue in the stanar re-orting"
Small enterprises
Auiting is a +unction o+ all #usinesses, no $atter ho! large or s$all"
In the case o+ large organisations, e3ternal auitors are re&uire +or auiting
o+ accounts"
Auitors are generally +ir$s o+ chartere accountants"
In the case o+ s$all enter-rises, the #usiness o!ner $ay -er+or$ the auiting
+unctions"
This $ay involve checking the #ooks an recors, revie!ing rano$
transactions, an checking $a9or ite$s such as #ank account #alances against
accounting recors"
This -rocess also has the avantage o+ -roviing a clearer unerstaning o+
the +inances an o-erations o+ the #usiness"
Auiting !ithin large organisations occurs !henever +or$al accounts are
-re-are, generally &uarterly o+ hal+<yearly" (>> check auiting o+
&uarterlyJannual accounts)"
2.8.4.5. 3ropert$ & E9uipment (estrution
5ro-erty an e&ui-$ent loss or estruction involves +ires, e3cessive !ear to
e&ui-$ent, an loss through the+t"
Prevention
Installing +ire alar$s, security -roceures an other ste-s $ay reuce the
chance o+ loss or a$age occurring to -ro-erty an e&ui-$ent"
183
This can range +ro$ si$-le security -roceures, through to co$-le3 an
e3-ensive -roceures involving on<site security $onitoring, +ire alar$s
linke to central $onitoring centres, an other -roceures"
This issue can rise in -ro+ile to a greater e3tent than the actual risk in so$e
#usiness o-erations, ho!ever all these events o occur, an the risk o+ these
things occurring shoul generally #e consiere !hen o-erating a #usiness"
2ire is a -articularly signi+icant risk"
7estruction o+ an entire -lant, incluing e&ui-$ent an +i3e +acilities,
co$-uter e&ui-$ent, in+or$ation recors, an stores o+ $aterials $ay #e
i++icult +or a #usiness to recover +ro$ in the short ter$"
Data "ackups
7ata #acku-s o+ co$-uter ata#ases an in+or$ation shoul generally #e
$aintaine on a regular #asis"
7ata #acku-s are usually store o++<site, to -revent loss in the event o+ a +ire"
'arious arrange$ents are use +or #acking u- ata"
As one e3a$-le, the +ull ata on a syste$ coul #e co-ie to ta-es each
night, !ith the -revious 30 ays ke-t in +ull, an then $onthly recors ke-t
-rior to that ate"
Also, #acku-s shoul #e regularly checke"
Tests shoul #e one to restore in+or$ation +ro$ #acku- +acilities into a
$ain +acility, to ensure that the #acku- in+or$ation is #eing store correctly,
contains all the in+or$ation, an can #e accesse"
7ata #acku-s +re&uently o not !ork !hen the +irst atte$-t is $ae to
restore ata +ro$ the$"
In so$e cases, large volu$es o+ etaile #acku-s have #een ke-t"
A+ter a syste$ +ailure, atte$-ts to restore that ata sho!e that all the ta-es
!ere #lank, that ata !as $issing, or that ata !as store in a corru-te
+or$at an coul not #e accesse"
An e++ective ata #acku- -roceure involves $any issues an is a signi+icant
-art o+ e++ective syste$s o-erations"
180
In the case o+ s$aller enter-rises, ata #acku-s $ay involve a !eekly #acku-
o+ the +ull syste$ on to ta-e, !ith the ta-es ke-t in an o++<site location"
So$e #acku- arrange$ents si$-ly kee- a co$-lete recor o+ the current
syste$ ata, !ithout any #acku- history"
Although this !oul #e su++icient to restore a syste$ to !orking orer, there
are t!o li$itations !ith this a--roach"
This syste$ relies on a single co-y o+ the ata"
I+ any ata ta-es or other storage ite$s are a$age or lost, it $ay not #e
-ossi#le to restore the ata"
Also, #acku- ata syste$s are also use to retrieve ata that has #een
accientally elete"
In the case o+ a single #acku- co-y o+ ata, the ata $ay #e -er$anently lost
i+ a ne! #acku- has #een store on the ta-e or other $eia since the ata !as
elete"
=o!ever, in the case o+ retaining -revious #acku- storage on a long ter$
#asis, in so$e cases the recovery o+ the elete ata $ay #e -ossi#le"
,arger co$-uter +acilities can inclue co$-letely u-licate +acilities, !ith
the a#ility o+ the syste$ to auto$atically s!a- +ro$ one +acility to another to
continue o-eration"
=o!ever, +acilities o+ this ty-e $ay #e e3-ensive, an the cost $ust
generally #e #alance against the -ractical ste-s that !oul #e neee to
restore a syste$ to !orking orer"
/aintenance
Maintenance o+ e&ui-$ent an -ro-erty $ay -revent an e3cessive reuction
in value over a short -erio o+ ti$e"
Although $aintenance can #e e3-ensive an is a signi+icant cost in so$e
o-erations, lack o+ regular -reventative $aintenance $ay result in e&ui-$ent
eteriorating at a ra-i rate"
18*
Also, a9usting e&ui-$ent regularly, in aition to scheule $aintenance,
$ay reuce +ault rates an -rouction sto--ages, an -revent e3cessive !ear
to e&ui-$ent occurring"
,nsurance
(eneral insurance is availa#le +or $ost -hysical ite$s use in #usiness,
incluing #uilings, e&ui-$ent, an $anu+acturing +acilities"
Insurance o+ this ty-e is usually cost<e++ective"
(eneral insurance o-erates in a co$-etitive an o-en $arket, an -re$iu$s
are calculate irectly +ro$ the -ro#a#ility o+ the ite$ #eing lost or
estroye"
Business continuity insurance can also #e arrange, to $ake -ay$ents +or
te$-orary +acilities until e&ui-$ent an +acilities can #e re-lace"
2.8.4.!. 8egal 4ssues
/lear legal ocu$entation is i$-ortant +or several reasons"
This $ay avoi -ro#le$s !ith $isunerstaning an con+usion, i++erent
-erce-tions, an $e$ories !hen events occurre a signi+icant -erio o+ ti$e
in the -ast"
Also, legal action is co$$on in #usiness, an in general a #usiness o+ any
signi+icant si@e $ust e3-ect that legal action !ill #e taken against it at so$e
ti$e or another"
Although the legal syste$ can #e slo! an e3-ensive, in so$e cases this is
also the only -ractical a--roach in atte$-ting to recover losses ue to
e+aults on -ay$ents an contracts"
/o$$ercial is-utes !ith custo$ers, su--liers an other -arties generally
-ass through an e3tene -erio o+ iscussions, letters, an all other atte$-ts
to resolve the situation #e+ore legal action is initiate"
Documentation
18)
The $ost i$-ortant issue involving $anaging legal issues is to ensure that
si$-le an clear ocu$entation is -rouce +or each arrange$ent involving
the #usiness"
This inclues loans, contracts !ith custo$ers an su--liers, +uns investe in
the #usiness, an e$-loy$ent agree$ents"
7ocu$entation oes not nee to use legal ter$s, or #e -articularly +or$al or
etaile"
All that is generally re&uire is a list o+ the key +acts, !ith the t!o -arties
signing the agree$ent"
This is also goo #usiness -ractice in the $anage$ent o+ a #usiness
o-eration, in aition to aressing legal issues"
In $ore co$-le3 cases, such as trust ees an $ortgages over -ro-erty, a
solicitor !oul nor$ally #e consulte to ra! u- ocu$entation"
,nsurance against legal action
Insurance can #e arrange to $eet the -ay$ents that $ay #e re&uire !hen
#eing sue uner several ty-es o+ legal action"
(>> check etails o+ insurancesJlia#ilities)
This incluesE
5u#lic lia#ility ,egal action taken #y custo$ers or other
$e$#ers o+ the -u#lic against the
#usiness, such as a custo$er in9uring
the$selves !hile on the #usiness
-re$ises"
5ro+essional ine$nity ,egal action regaring negligence, as a
irector, trustee, -ro+essional service
-rovier or other situation !here the
#usiness or iniviual is sue +or
negligence"
DorkerCs co$-ensation /o$-ensation -ay$ents +or e$-loyees
in9ure !hile !orking !ithin the
#usiness o-erations" Se-arate issues arise
188
in relation to negligence o+ the #usiness
o-erator"
Prevention
5revention o+ a legal situation arising is a +ar #etter result that ealing !ith
the -ro#le$ a+ter it has alreay occurre"
This involves the general e++icient an e++ective o-eration o+ the #usiness,
such as elivering -roucts an services to custo$ers accoring to
s-eci+ications an !ithin the ti$e -erio s-eci+ie, an $eeting -ay$ents to
su--liers as they #eco$e ue"
Possession
Although the legal syste$ su--orts an en+orces #ining contracts, in $any
-ractical cases, -hysical -ossession o+ ite$s or +uns has greater i$-ortance
+or the #usiness"
2or e3a$-le, i+ a large ite$ o+ e&ui-$ent !as elivere to a custo$er, an
then -ay$ent !as not $ae, legal action coul #e taken to recover the
-ay$ent"
A court !oul generally consier that a contract !as in -lace, an !oul
generally issue a court orer that -ay$ent #e $ae"
I+ the -ay$ent !as still not $ae +ollo!ing court orers, this coul -rocee
to a #ankru-tcy or li&uiation o+ the custo$erCs assets an to re-ay the
outstaning e#ts"
=o!ever, this -rocess coul take $onths or even years, !ith large costs
involve until the case !as eter$ine"
7uring this ti$e, the #usiness !oul have neither the +uns nor the
e&ui-$ent, !hich coul cause $a9or cash +lo! -ro#le$s"
In so$e cases, a #usiness #eco$es insolvent an is li&uiate, #e+ore the
court 9uge$ent is +inally $ae in +avour o+ the #usiness so$e ti$e later"
The -otential risk o+ these -ro#le$s arising can #e reuce #y using $ethos
such as e-osits, -rogress -ay$ents uring -ro9ect evelo-$ent, an other
181
a--roaches that consier the -hysical -ossession o+ the -ro-erty as !ell as
the legal status o+ the situation"
2.8.4.7. 3ro%et ris6
5ro9ect risk relates to the risk that so$e o+ the +ollo!ing events $ay occurE
The -ro9ect is not co$-lete on ti$e"
The -ro9ect cannot #e co$-lete !ithout aitional +uning a#ove
#uget"
The -ro9ect +ails to -rouce its goal, such as research to evelo- a
ne! techni&ue"
The co$-lete structure oes not $atch the s-eci+ication +or the
-rouct"
The -ro9ect #eco$es a continuous -rocess, !ithout any clear
-rogress or co$-lete ite$s #eing -rouce"
The en result o+ the -ro9ect $ay #e also #e unsuccess+ul, ho!ever this is a
se-arate issue +ro$ the risk o+ co$-leting the -ro9ect itsel+
Pro2ect management
%++ective -ro9ect $anage$ent is the $a9or issue in avoiing -ro9ect risks"
This involves evelo-ing a scheule an -ro9ect -lan involving the tasks to
#e co$-lete, the ti$e +ra$es, an the orer o+ various tasks"
Managing the -ro9ect then involves changing the orer an ti$ing o+ tasks as
the -ro9ect -rogresses, an ensuring that the -ro9ect re$ains on scheule an
!ithin #uget"
Commencing pro2ects
It is i$-ortant to not co$$ence a -ro9ect unless there is su++icient +uning to
see the -ro9ect through to co$-letion"
186
This relates to the #usiness continuing to o-erate an evelo- on an e++ective
#asis"
More i$-ortantly, the $o$ent that a -ro9ect co$$ence, the -ro9ect $oves
into signi+icant negative territory"
I+ the -ro9ect continues through to co$-letion, the situation $ay return to the
-revious conitions #e+ore the -ro9ect co$$ence"
=o!ever, i+ the -ro9ect +ails $i<!ay through, $a9or losses $ay #e incurre"
This occurs #ecause o+ the +act that a -artially co$-lete -ro9ect o+ten has
little or no value"
2or e3a$-le, an a-art$ent #uiling $ay #e constructe +or resiential use"
The -ro9ect $ay #e -artially co$-lete, ho!ever there $ay #e insu++icient
+uning to +inish the -ro9ect"
In this case, the only o-tion !oul #e to sell the -ro9ect to another #usiness,
!hich !oul co$-lete the -ro9ect an sell the +inishe #uiling"
In $any cases a #uyer $ay not #e availa#le, !hile in other cases a lo! -rice
!oul #e -ai, ue to the costs an co$-le3ity involve in taking over the
-ro9ect"
A -ro9ect that is 100L co$-lete $ay have a value o+ 100L o+ co$-lete
value, ho!ever -ro9ect that is 60L co$-lete $ay have a value o+ only 20L
o+ the +inal value, +or e3a$-le"
/o$$encing -ro9ects that are +una$entally too large +or the #usiness to
+un is a co$$on source o+ #usiness o-erations ening an #usinesses #eing
li&uiate"
Pro2ect results
A -ro#le$ that so$eti$es occurs !ith -ro9ects is that the +inishe -ro9ect
oes not $atch the re&uire$ents that the client !as e3-ecting"
Dhen the ti$e an e3-enses have alreay #een s-ent #y the ti$e the -ro9ect
is +inishe, it is then too late to alter the esign"
110
This is a $a9or source o+ legal action in #usiness, !ith the client atte$-ting
to recover costs +ro$ the evelo-er, an the evelo-er atte$-ting to recover
+ull -ay$ent +ro$ the client"
These -ro#le$s $ay #e reuce #y +ollo!ing several ste-s"
This incluesE
%nsuring that the original s-eci+ications are etaile an cover all
areas, an are signe #y the client #e+ore evelo-$ent co$$ences"
7e$onstrating $ock<u-s, $oels an -rototy-es to the client, to
ensure that the esign $atches the clientCs e3-ectations"
%nsuring that the client revie!s -rogress at several stages through
the -ro9ect, so that the irection o+ the -ro9ect can #e change at an
early stage i+ necessary"
%nsure that -rogress -ay$ents are receive uring evelo-$ent, to
reuce cash +lo! -ro#le$s i+ later court action results in long elays
#e+ore +inal -ay$ent is receive"
This issue arises !ith the #usiness #eing either a client o+ an e3ternal service
-rovier, or a evelo-er o+ a -ro9ect +or an e3ternal client"
Staged development
Stage evelo-$ent $ay signi+icantly reuce -ro9ect risks"
In this arrange$ent, a large -ro9ect is ivie u- into several ine-enent
stages"
The +irst stage $ay #e co$-lete, an in so$e cases sol, #e+ore later stages
are co$$ence"
This a--roach also ena#les the #usiness to $ake a ecision on a +uture ate,
$i<!ay through the -ro9ect, !hen conitions $ay have change
signi+icantly"
Progress pa*ments
111
In the case o+ internally +une -ro9ects, such as evelo-ing ne! -roucts,
inco$e +ro$ the -ro9ect is not -ossi#le until the -ro9ect has #een co$-lete"
=o!ever, in the case o+ -ro9ects evelo-e +or clients, various -ay$ent
$ethos can #e use to reuce the risk o+ cash +lo! -ro#le$s"
These inclue -ay$ents at regular -erios, -ay$ents !hen -ro9ect
$ilestones are reache, an e3-enses #ille irectly to the client !ith a +ee
charge +or organising an $anaging the -ro9ect"
2.8.4.8. ,is6s (ue to finanial struture
2.8.4.8.1. Debt
%3cessive e#t can #e a $a9or source o+ risk to a #usiness"
Most #usinesses have so$e e#t"
This $ay #e e#t that !as raise to -urchase e&ui-$ent, to +un e3-ansion
into ne! areas an $arkets, or +or !orking ca-ital re&uire$ents !hen large
-ay$ents $ust #e $ae #e+ore inco$e a$ounts are receive"
Ane scenario $ay involve a #usiness -urchasing e&ui-$ent to e3-an
o-erations, !hile at a later ate a -erio o+ slo! sales occurs, asset values
an cash +lo! ecline, an the #usiness is le+t !ith a large e#t an serious
+inancial -ro#le$s"
Businesses !ith sta#le cash +lo!s can generally sustain higher levels o+ e#t
than #usinesses !ith volatile cash +lo!s"
This inclues e3a$-les such as -ro-erty an in+rastructure invest$ent, an
general #usiness o-erations in sta#le $arkets"
Business !ith unsta#le an irregular inco$e can sustain only lo!er levels o+
e#t"
%3a$-les inclue -ro9ect evelo-$ents such as +il$ -rouction an
#iotechnology, an start<u- o-erations !ith negative cash +lo!"
T!o $a9or $easures o+ the e#t level are a :gearing; ratio an an :interest
cover; ratio"
112
(earing can #e calculate in several !ays, !ith the ratio o+ e#t to total
assets #eing one a--roach"
(earing values using this calculation are o+ten !ithin the 20L to *0L range"
A gearing ratio o+ 30L, +or e3a$-le, inicates that 30L o+ the #usiness
assets are +une !ith e#t, !hile the re$aining 80L o+ the asset value is
e&uity o+ the #usiness"
(earing levels o+ signi+icantly a#ove *0L $ay suggest a risk e3-osure to
high e#t levels"
A+ $ore irect relevance is the interest cover ratio, !hich $easures the
-ro-ortion o+ inco$e that is re&uire to $eet e#t -ay$ents"
This is calculate +ro$ the net inco$e #e+ore interest an ta3, ivie #y the
interest e3-ense"
'alues #elo! +ive $ay suggest a risk ue to high e#t levels, !ith an interest
cover ratio uner * suggesting that $ore than 20L o+ net inco$e is use to
$eet interest -ay$ents"
In these cases, action coul generally #e taken to reuce e#t levels #e+ore a
serious -ro#le$ evelo-e"
This $ay involve raising aitional e&uity +uns +ro$ investors to re-ay
e#t, reucing or cancelling iviens until e#t !as reuce, an
-ost-oning $a9or e3-enses such as evelo-$ent -ro9ects"
The general e++ectiveness o+ the #usiness structure an o-erations $ay also
i$-act heavily on the cash +lo! availa#le to reuce e#t levels"
2.8.4.8.2. -argins
A #usiness that o-erates !ith narro! $argins $ay #e at risk o+ negative cash
+lo! i+ costs rise slightly or sales +all"
2or e3a$-le, a #usiness $ay have inco$e o+ G100 +or the year !ith e3-enses
o+ G61, +or a net inco$e o+ G2"
This $argin o+ 2L is a lo! +igure, ho!ever so$e inustries such as -etrol
retaining an su-er$arkets o-erate !ith $argins o+ only a +e! -ercent"
113
In this case, i+ e3-enses !ere to rise +ro$ G61 to G66, or inco$e !as to +all
+ro$ G100 to G66, then net inco$e !oul +all #y hal+"
Inustries that o-erate !ith lo! $argins generally also o-erate !ith large
volu$es"
Dithin other inustries, the average $argin $ay #e high"
This a--lies to lo! volu$e sales o+ custo$ise -roucts, +or e3a$-le"
I+ the $argin o+ the #usiness is lo!, or is signi+icantly #elo! the inustry
average, then this $ay -resent a risk to the #usiness"
This can #e $anage through care+ul cost control"
In cases !here the $argin is #elo! the inustry average, this $ay involve
increasing -rices, reinvest$ent in ne! +acilities, or a range o+ other changes
to restore the $argin to a $ore sustaina#le level"
2.8.4.8.3. /i)e( +osts
2i3e costs are e3-enses that o not change !hen the volu$e o+ -rouction
changes"
These inclue #uiling rents, e-reciation o+ e&ui-$ent, an general
a$inistration costs"
'aria#le costs change !ith -rouction volu$es an inclue costs o+ ra!
$aterials, an -ossi#ly e3ternal services"
The ratio o+ +i3e costs to total costs can #e calculate over a -erio o+ ti$e,
to eter$ine the -ro-ortion o+ costs that cannot #e reuce i+ sales +all"
2igures such as these can also #e co$-are to inustry averages"
A #usiness !ith a high -ro-ortion o+ +i3e costs generally i$-lies that a large
an co$-le3 -rouction +acility has #een create"
This $ay #e a -hysical $anu+acturing -lant, or it $ay #e an organisation that
-rocesses a large volu$e o+ services"
This re-resents a risk to the #usiness i+ sales shoul +all, as the +i3e costs
cannot easily #e reuce to $atch the +all in inco$e"
110
Averca-italisation occurs !hen a +acility is create that has a ca-acity that is
greater than the unerlying e$an +or the -rouct"
In these cases, alternatives coul inclue e3-aning sales into a !ier
geogra-hic region, such as e3-ort sales, creating ne! -roucts to use the
ca-acity o+ the +acility, an -er+or$ing contract $anu+acturing or services
+or other #usinesses"
In other cases, ne! invest$ent $ay #e re&uire to reuce +i3e costs, or
$arketing e++orts $ay nee to #e increase to ensure that the -rouction
+acility is +ully utilise"
2.8.5. 1eneral ris6 management
(eneral #usiness risks involve a !ie range o+ circu$stances that coul have
a etri$ental e++ect on the #usiness"
A nu$#er o+ a--roaches can #e use to structure the #usiness o-eration so
that the -otential i$-act o+ these events on the #usiness $ay #e reuce"
2.8.5.1. Ba6up failities
Backu- +acilities can #e use to allo! #usinesses to continue o-eration !hen
an e3isting source o+ su--ly ceases to o-erate"
This $ay #e a su--ly o+ ra! $aterials, the ata storage !ithin a co$-uter
+acility, or the cash +lo! +ro$ sales"
Backu- +acilities inclue the +ollo!ingE
2uning su--lies, incluing creit +acilities such as overra+ts, cash
#alances, an holings o+ li&ui assets such as shares"
These can #e use to hanle cash +lo! -ro#le$s ue to e3-enses
#eing ue #e+ore inco$e is receive, a large -ay$ent #eing re&uire
such as an e&ui-$ent re-lace$ent, or generally -oor o-erating
conitions"
11*
Back u- o+ co$-uter ata +iles"
Back u- co$-uter har!are +acilities"
S-are ite$s o+ e&ui-$ent, s-lit +acilities, an using several
$achines rather than one large one to allo! -rouction to continue
!hen e&ui-$ent is te$-orarily unavaila#le"
Arrange$ents !ith alternative su--liers
Testing #acku- +acilities is an i$-ortant issue"
Backu- +acilities that are not o-erate regularly $ay not +unction i+ the
-ri$ary source +ails an the #acku- +acility is re&uire"
2or e3a$-le, ata #acku- ta-es shoul #e restore to a $ain syste$ on a
regular #asis, #acku- generators shoul #e regularly starte, an
arrange$ents !ith su--liers shoul #e regularly con+ir$e"
Ane alternative to reuce these -ro#le$s involves o-erating the #acku-
+acility as -art o+ regular o-erations"
2or e3a$-le, s$all &uantities o+ goos coul #e regularly -urchase +ro$ a
#acku- su--lier, to ensure that account etails, shi--ing arrange$ents an
-rouct su--lies !here all o-erating correctly"
In the case o+ alternative +acilities, so$e arrange$ents involve s!itching
+ro$ a $ain +acility to an alternative +acility on a regular #asis, to ensure that
#oth +acilities are +ully o-erational"
Another har!are arrange$ent $ay reuce the risk o+ #acku-s not #e
availa#le !hen they are neee $ay involve the #acku- +acility #eing
-er$anently connecte to the $ain +acility, rather than #eing s!itche in
!hen a -ro#le$ occurs"
This a--roach $ay also reuce the nee to etect error conitions an s!itch
arrange$ents"
2or e3a$-le, the +ailure o+ the $ain syste$ $ay lea to su--ly #eing
auto$atically ra!n +ro$ the alternative source that is connecte !ithin the
su--ly syste$"
11)
Battery #acku- syste$s that are -er$anently connecte in the su--ly circuit
$ay #e an e3a$-le o+ this a--roach"
So$e +inancing arrange$ents, such as overra+ts on che&ue accounts, coul
also #e consiere to #e a structure o+ this ty-e"
2.8.5.2. Offsetting ris6s
In so$e cases, a ne! risk can also #e taken on that -artially cancels an
e3isting risk, #y o-erating in the o--osite irection"
2or e3a$-le, an agree$ent !ith a custo$er $ay #e signe to su--ly a
-rouct at a +i3e -rice +or a +i3e -erio o+ ti$e"
This !oul create a risk i+ in-ut -rices rose or su--lies #eca$e unavaila#le"
Signing a +i3e su--ly agree$ent also creates a risk, as the #usiness !oul
receive su--lies +or a +i3e -erio o+ ti$e, regarless o+ !hether or not there
!as a e$an +or the +inal -rouct"
=o!ever, #ecause the initial agree$ent to su--ly the -rouct !as in -lace,
this secon risk !oul o++set the +irst risk an lea to a reuce total risk"
As a $ore irect e3a$-le, an overseas -ro-erty such as a storage !arehouse
$ay #e -urchase"
The #usiness !oul then #e e3-ose to changes in the value o+ this asset ue
to changes in the value o+ the currency e3change rate"
=o!ever, i+ a loan !as taken out to -urchase the #uiling in the sa$e
currency, rather than the local currency, this !oul o++set the risk o+ the
#uiling"
Both the loan value an the #uiling value !oul rise o+ +all at the sa$e ti$e,
leaing to a reuce change in the net i++erence #et!een the t!o"
A++setting risks $ay create a +alse sense o+ security in so$e circu$stances"
2or e3a$-le, risks rarely o++set e3actly, an t!o risks that a--eare to o++set
each other $ay only -artially o++set at ti$es"
Also, other -arties $ay e+ault on contracts, an situations $ay arise that
lea to one o+ the risks isa--earing, !hile the other re$ains in -lace"
118
In the !arehouse e3a$-le, i+ the !arehouse !as estroye #y +ire, then the
e3-osure to the e#t !oul suenly a--ear as a $a9or risk e3-osure"
This -ro#le$ is -articularly signi+icant !hen one risk isa--ears an the
other $oves signi+icantly at the sa$e ti$e, #e+ore the secon risk can #e
un!oun"
This -ro#le$ so$eti$es occurs in invest$ent traing -ort+olios an hege
#ooks use to $anage risks such as +oreign e3change, interest rate an
co$$oity -rice e3-osures"
In the case o+ o++setting risks, the iniviual risks re$ain in -lace an shoul
#e #orne in $in as !ell as the total net -osition"
=o!ever, o++setting risks can lea to a rastic reuction in the net risk to the
#usiness"
2.8.5.3. #ingle :s -ultiple arrangements
A $a9or source o+ risk $ay occur !hen a #usiness is reliant on a single
custo$er or su--lier"
This creates a e-enency #et!een each -arty that -revents either -arty +ro$
o-erating ine-enently"
Also, this creates a $a9or source o+ risk to the #usiness in the event that the
other -arty ceases to su--ly goos or orer -roucts, +or one reason or
another"
In so$e inustries this is unavoia#le, in cases !here the inustry is
consoliate into several $a9or o-erations"
This occurs !ithin inustries that #ene+it +ro$ econo$ies o+ scale, !here the
inustry consoliates into several su--liers, !ith large volu$es an lo! -er<
unit costs"
Dere it is -ossi#le, ho!ever, evelo-ing a !ie custo$er #ase an sourcing
su--lies +ro$ several su--liers $ay have a signi+icant i$-act on the
#usiness"
This !oul allo! the #usiness to act ine-enently o+ the actions o+ any
-articular custo$er or su--lier"
111
This $ay also s$ooth cash +lo!, an greatly reuce the i$-act on the
#usiness o+ a custo$er cancelling orers, o+ a su--lier ceasing to su--ly"
This -rinci-le is the #asis o+ the o-eration o+ $arkets o+ all kins, insurance
-ort+olios containing $any iniviual risks, an invest$ent -ort+olios using a
range o+ invest$ents to iversi+y the -ort+olio an reuce the volatility o+
returns"
2.8.5.4. #ingle*pro(ut ris6
Many #usinesses o-erate success+ully +or long -erios as a single<-rouct
co$-any"
The -rouct $ay #e a co$-uter -rogra$, a s-ecialise ite$ o+ e&ui-$ent, or
a -articular service"
In these cases, the #usiness itsel+ $ay #e #uilt aroun the -rouct"
/ash +lo! $ay #e steay an sustaina#le, !ith a sta#le $arket o+ custo$ers"
=o!ever, all -roucts have a li$ite li+e, an graually loose relevance as
the !orl aroun the$ changes"
A -rouct $ay #e continually u-ate an change, #ut as ti$e goes #y, the
unerlying structure o+ the original -rouct #eco$es less an less suita#le as
a #asis +or the -rouct"
This situation also -resents a risk to the #usiness i+ a co$-etitor !ere to
une3-ectely release a -rouct that -er+or$e si$ilar +unctions"
In the case o+ single<-rouct #usinesses, using the availa#le cash +lo! to
evelo- ne! -roucts or services $ay reuce the risk o+ a long<ter$ ecline,
or suen colla-se, in the o-erations o+ the #usiness"
=o!ever, evelo-ing a large nu$#er o+ -roucts also has -ro#le$s"
5rouct evelo-$ent $ay #e a slo! an e3-ensive e3ercise"
Multi-le -roucts $ay re&uire a !ie range o+ ra! $aterials, co$-le3
a$inistration an -rouction, high $aintenance levels, an lo! volu$es -er
-rouct"
116
A-eration $ay #e si$-le an e++icient !hen a large volu$e o+ a +e!
-roucts is $ae, rather than s$all volu$es o+ $any -roucts"
7evelo-ing co$-letely ne! -roucts on a regular #asis $ay allo! the
#usiness to continue a sustaina#le o-eration over the long ter$, rather than
graually eclining over ti$e"
2.8.5.5. /le)ibilit$
2le3i#ility is +una$ental to survival"
Hne3-ecte events occur +ro$ ti$e to ti$e, !hile the structure o+ inustries
an the econo$y is constantly changing"
2le3i#ility allo!s the #usiness to aa-t to changing conitions, an reuces
the chance o+ insolvency !hen averse events occur"
So$e alternatives +or $aintaining +le3i#ility inclue the +ollo!ingE
,easing -re$ises rather than -urchasing -ro-erty"
Maintaining short<ter$ or $eiu$<ter$ leases"
Avoiing long<ter$ +i3e<-rice contracts !ith custo$ers or
su--liers"
Maintaining cash #alances an creit +acilities to allo! transactions
to #e unertaken"
Incluing o-tions !ithin contracts, such as a t!o year #uiling lease
!ith an o-tion +or a +urther t!o years"
Hsing e3ternal services rather than internal services"
,easing e&ui-$ent to allo! ca-ital to #e ke-t in $ore li&ui +or$s
such as cash #alances an traea#le securities"
Avoiing long creit ter$s an long<ter$ +i3e rates, such as
o++ering long creit ter$s to custo$ers, or using +i3e interest rates
+or long ter$ loans"
160
2.8.5.!. 4nsurane
Insurance can #e use to reuce the i$-act o+ certain events"
Insurance !ithin the #usiness conte3t +alls into several categories"
(eneral insurance covers -hysical ite$s such as e&ui-$ent, #uilings,
-rouction +acilities an inventories o+ $aterials"
,egal lia#ility insurance covers -ay$ents that $ay #e re&uire ue to court
action against the #usiness"
Ather insurances inclue #usiness continuity insurance, !hich involves
-ay$ents to arrange te$-orary +acilities in the event o+ a $a9or -ro#le$ such
as a +ire"
In this case, the insurance -olicy $akes -ay$ents to allo! te$-orary
+acilities to #e arrange, e&ui-$ent to #e hire, an ra! $aterials to #e
-urchase to allo! the #usiness to kee- o-erating until the +ull +acilities are
restore"
Insurance -re$iu$s are calculate accoring to the -ro#a#ility o+ the event
occurring, an the si@e o+ the -ay$ent that !oul #e involve"
Insurance in the co$$ercial conte3t is generally a co$-etitive inustry, !ith
insurance #eing cost<e++ective in $any cases"
In so$e areas, certain ty-es o+ insurance, such as legal lia#ility insurance,
can #e e3-ensive ue to a large a$ount o+ litigation an large -ay$ents that
$ay #e involve"
'arious ste-s can so$eti$es #e taken to reuce the risk o+ an event
occurring"
2or e3a$-le, a +ire alar$ $ay #e installe in a #uiling to reuce the risk o+
the #uiling #eing estroye #y +ire"
In so$e cases, the -re$iu$s o+ insurance -olicies $ay #e lo!er !hen ste-s
such as these are taken, ue to the lo!er risks"
%3a$-les o+ insurance inclueE
161
(eneral insurance %&ui-$ent, stock, #uilings, vehicles, $anu+acturing
+acilities"
,egal ,ia#ility 5u#lic lia#ility (accients, e+ective goos),
5ro+essional ine$nity (negligence as a irector etc)
DorkerCs co$-ensation
Ather Business continuity
2.8.5.7. 8ong*term agreements
,ong ter$ agree$ents can re-resent a #ene+it or a risk to the #usiness"
This a--lies to custo$er su--ly contracts, su--lier arrange$ents, -ro-erty
an e&ui-$ent leases, an so on"
In one e3a$-le, a steay strea$ o+ custo$er orers $ay #e receive +ro$ a
range o+ i++erent custo$ers"
=o!ever, the #usiness $ay have continual -ro#le$s !ith su--lies, !ith
su--liers elivering goos in various &uantities at i++erent ti$es, !ith
+re&uent shortages"
In this circu$stance, a $eiu$ ter$ agree$ent !ith a su--lier +or sta#le
su--ly volu$es $ay have consiera#le #ene+it to the #usiness"
Also, in cases !here long<ter$ agree$ents can #e $ae !ith #oth su--liers
an custo$ers, this $ay -rovie a -erio o+ sta#le cash +lo!"
Sta#le cash +lo! !oul allo! aitional risks to #e unertaken, such as a
ne! -ro9ect evelo-$ent or a higher level o+ e#t"
In general, ho!ever, long ter$ agree$ents $ay re-resent a risk to the
#usiness"
Inustries, the econo$y, an iniviual #usinesses change continuously"

%3-ecte events $ay also occur that $ay re&uire a signi+icant change in the
irection o+ the #usiness"
162
,ong ter$ agree$ents $ay -revent the #usiness +ro$ aa-ting to change
circu$stances"
All else #eing e&ual, a long ter$ +i3e arrange$ent carries $ore risk than a
shorter<ter$ +i3e arrange$ent"
More changes $ay occur over the ter$ o+ a long<ter$ contract, an i+ the
contract #eco$es un+avoura#le, a longer -erio o+ loss $ay occur until the
contract e3-ires"
In general, +le3i#ility is i$-rove !hen long<ter$ agree$ents are avoie"
2.8.!. #ummar$ of ris6 management
So$e o+ the +ollo!ing $ethos can #e use to reuce the i$-act that at an
event $ay have on the o-erations o+ the #usiness"
Risk Trans+er Insurance, +inancial $arkets o-tions, setting out-ut
-rices to in-ut -rices -lus a $argin"
Risk I$-act 2le3i#le o-erations, #acku- +acilities"
Risk 5ro#a#ility 5revention, +or e3a$-le, +ire alar$s, e&ui-$ent
$aintenance, accurate su--lies to custo$ers, -ro9ect
$anage$ent"
Risk A++sets 2utures contracts, sourcing su--lies in the sa$e currency
as e3-orts, holing e#t in the sa$e currency as asset
e3-osures"
Risk S-litting Boar custo$er #ases, $ulti-le su--liers, several
-roucts, stage evelo-$ents"
Risk 7e+ence ,egal ocu$entation
163
... The economy/ in(ustries an( change
As ti$e -asses, so$e inustries ecline in si@e, !hile ne! inustries a--ear"
This can #e ue to ne! technology an to changes in social conitions"
Many -roucts have an unerlying e$an !ithin the econo$y"
As ne! technology is evelo-e an i$-le$ente, the -roucts $ay #e
-rouce using +e!er an +e!er resources"
2or e3a$-le, agriculture !as once a $a9or -art o+ the econo$y"
The nu$#er o+ -eo-le involve in agriculture, an the a$ount o+ resources
neee to gro! +oo an -rouce other agricultural -roucts is no! &uite
s$all"
4e! technology o+ten results in reuce in-ut $aterials +or the sa$e volu$e
o+ -rouction, an reuce $anual in-ut"
4e! !aves o+ technology $ay lea to une$-loy$ent, as the e3isting
e$an is $et !ith +e!er resources"
=o!ever, ne! inustries then s-ring u- in -lace o+ the !ork that !as
-er+or$e #e+ore"
2or e3a$-le, !hen stea$ -o!er !as +irst !iely use, knitting $achines
-rouce !oollen gar$ents in a short -erio o+ ti$e +or al$ost no cost asie
+ro$ the !ool"
5reviously, a large inustry ha #een involve !ith large nu$#ers o+ -eo-le
knitting gar$ents #y han"
This change lea to !ies-rea une$-loy$ent"
2actories !ere attacke, an ar$e guars !ere statione #esie the
$achines"
The !or :sa#otage; is erive +ro$ the !or :sa#ot;, !hich is a ty-e o+
!ooen shoe"
The sa#ot !ere thro!n into the $achines to #reak the e&ui-$ent an -revent
-rouction"
160
Aver ti$e ne! inustries arose, although this i not occur i$$eiately"
At the ti$e o+ !riting, #anking is changing +ro$ a la#our intensive inustry
to a technology intensive inustry"
Mining is eclining in si@e as a -ro-ortion o+ the econo$y, as i$-rove$ents
in technology ena#le the sa$e $aterials to #e $ine !ith less cost an in-ut
than in the -ast"
Mining !as originally a la#our intensive inustry, #ut is no! a ca-ital
intensive inustry, !ith +e! e$-loyees o-erating large an highly e++icient
$ining e&ui-$ent"
At one ti$e, $ining co$-anies co$-rise aroun 10L o+ the ca-italisation
o+ the Australian stock $arket, ho!ever this has no! ecline to aroun
1*L"
,a#our<intensive inustries ten involve a large nu$#er o+ s$all an
$eiu$s si@e organisations"
/o$$unication, a$inistration an $anage$ent !ithin la#our<intensive
#usinesses #eco$es $ore i++icult at the si@e o+ a #usiness gro!s"
In contrast, ca-ital intensive inustries ten to consoliate into a s$all
nu$#er o+ large organisations"
The is ue to the +act that the +i3e costs, such as $anu+acturing +acilities an
$ining e&ui-$ent, can #e s-rea across a larger nu$#er o+ ite$s !hen high
volu$es are involve, leaing to lo!er costs -er unit +or high volu$e
-rouction"
Service #usinesses are the gro!th sector o+ the econo$y"
This is relate to the +act that the unerlying e$an +or -hysical -roucts is
no! #eing $et using a s$all nu$#er o+ e$-loyees, involving high volu$e
+acilities an avance technology"
This e++ect also occurs !ithin inustries that -reviously e$-loye a large
nu$#er o+ sta++ to -er+or$ $anual a$inistration, an !here co$-uterise
-rocessing is no! heavily use"
Banking an insurance are e3a$-les o+ this"
16*
These changes $ay have allo!e ne! inustries to a--ear, ue to -rouction
o+ -hysical -roucts no longer re&uiring the activity o+ large nu$#ers o+
e$-loyees"
The structure o+ the econo$y changes constantly, although this is a long ter$
an graual change"
The structure o+ an inustry $ay i$-act the strategy an o-eration o+ a
#usiness"
A #usiness o-erating in a eclining inustry $ay nee to regularly #uy other
#usiness, consoliate o-erations an e3-an volu$es in orer to re$ain
-ro+ita#le"
A #usiness o-erating in an e3-aning inustry $ay +in that co$-etition is
intense, an that constant ne! -rouct evelo-$ent is re&uire in orer to
-revent +alling #ehin the evelo-$ent o+ the inustry"
.10. Employment
Most #usinesses e$-loy sta++ in one +or$ or another"
%$-loyees are hire to -er+or$ a !ie range o+ tasks"
In $anu+acturing, e$-loyees are hire to o-erate $achinery, scheule an
$anage -rouction -rocesses, an liaise !ith custo$ers an su--liers"
In #uiling construction, e$-loyees are hire +or $anual la#ouring, trae
services, an general construction"
Services #usinesses e$-loy sta++ to -rovie services to clients, $aintain
co$-uter services, an -rouce $arketing $aterial"
(eneral a$inistration involves $aking -ay$ents, -rocessing transactions,
an recoring in+or$ation such as current arrange$ents !ith custo$ers"
A-erations are $anage in various !ays"
Su-ervisors oversee the !ork o+ e$-loyees !ho are not e3-erience in the
task #eing -er+or$e"
This $ay -revent -ro#le$s arising ue to $istakes such as in+or$ation #eing
-rocesse incorrectly"
16)
The su-ervisor also acts as a re+erence -oint +or technical issues an
-ro#le$s that arise"
Tea$ leaers $anage the o-eration o+ a tea$"
This inclues #uiling the tea$, an hiring an +iring $e$#ers o+ the tea$"
The tea$ leaer is generally e3-erience in the task #eing -er+or$e, an
-er+or$s the !ork on a ay to ay #asis along !ith the other $e$#ers o+ the
tea$"
The tea$ leaer ensures that -ro9ects re$ain on scheule, or that !orkloas
are #eing $et"
Tea$s $ay #e co$-ose o+ several e$-loyees -er+or$ing the sa$e task,
such as a tea$ o+ engineers !orking on a large -ro9ect"
In other cases, several i++erent skills $ay #e involve"
2or e3a$-le, a tea$ co$-rising a $arketing -erson, the -rouct $anager,
an a technical sta++ $e$#er $ay #e asse$#le to create a -ro-osal +or a
-resentation to a -otential client"
A-erational $anage$ent involves organising the activities o+ the #usiness"
This $ay involve assigning tea$s to -ro9ects, hiring an +iring e$-loyees,
negotiating !ith su--liers, an hanling -ro#le$s that arise !ith the
o-eration o+ the #usiness"
5ro9ect $anage$ent involves -lanning an $anaging s-eci+ic -ro9ects"
A etaile -ro9ect -lan $ay #e -rouce containing a list o+ tasks that are
re&uire to co$-lete the -ro9ect, together !ith the orer an ti$ing o+ each
o+ the i++erent -arts o+ the -ro9ect"
Multi-le iniviuals or tea$s $ay #e involve in !orking on an iniviual
-ro9ect"
Managing the -ro9ect $ay involve re<scheuling tasks as events un+ol,
hanling -ro#le$s !ith su--lies or in+or$ation +ro$ e3ternal -arties, an
changing resources as the -ro9ect -rogresses"
Strategic $anage$ent involves -lanning the +uture irection an
evelo-$ent o+ the #usiness"
168
This $ay involve -lanning the $a9or -rouct areas an $arkets that the
#usiness !ill o-erate in, closing an +or$ing #usiness units, negotiating +or
the -urchase o+ other #usinesses or +or$ing 9oint ventures !ith other
co$-anies, an -lanning the +inancial structure o+ the #usiness"
In so$e s$all enter-rises, an o++ice $anager is e$-loye to -er+or$ general
a$inistration, orer su--lies an $aintenance, an kee- #asic accounts"
-*pes of emplo*ment
5er$anent e$-loyees are hire as -art o+ the ay<to<ay o-eration o+ the
#usiness"
Te$-orary sta++ are e$-loye to +ill in +or other e$-loyees !ho are on
leave, or uring ti$es o+ -eak !orkloa"
/ontract sta++ are hire to co$-lete a s-eci+ic -ro9ect, or uring $eiu$ ter$
-erios o+ high activity"
Pa*ment
/ontract an te$-orary sta++ are generally -ai accoring to an hourly rate
+or hours !orke less #reaks"
In so$e cases, a aily rate $ay a--ly"
5er$anent sta++ are generally -ai a +i3e annual salary"
In so$e cases, -articularly in so$e s$all<scale $anu+acturing o-erations,
-ay$ent $ay #e #ase on a +i3e a$ount +or each ite$ -rouce or +or each
task -er+or$e"
Re$uneration can inclue non<cash -ay$ents such as the use o+ a car"
In general the total re$uneration is a +i3e ollar a$ount"
In so$e cases, an e$-loyee $ay chose to take the +ull a$ount in cash, or a
$i3 o+ cash an other #ene+its such as a car lease"

Bonuses are use in so$e re$uneration arrange$ents"
These are lu$- su$ a$ounts, rather than regular -ay$ents"
161
A #onus is usually o-tional, an is linke to a +or$ula #ase on so$e
$easure o+ the results achieve #y the e$-loyee, tea$ or co$-any"
Sales sta++ are so$eti$es -ai on a co$$ission #asis, !hich $ay inclue a
#ase salary, an a -ercentage co$$ission o+ each ite$ sol"
1rganisation structures
%$-loying sta++ is e3-ensive" 5ay$ents to e$-loyees are a $a9or cost ite$
in $ost #usinesses" In so$e service #usinesses, sta++ costs +or$ the #ulk o+
the e3-enses"
In aition to irect -ay$ents, costs o+ o++ice s-ace, co$-uter e&ui-$ent,
an training $ay #e re&uire"
As a rough rule o+ thu$#, the total cost o+ e$-loying a $e$#er o+ sta++ $ay
#e a--ro3i$ately ou#le the irect salary cost"
An intangi#le cost also a--lies to #usinesses that evelo- co$-le3
organisational structures"
In these cases, the #usiness $ay loose irection an clarity"
,arge nu$#ers o+ e-art$ents $ay interact in a !ie range o+ i++erent
!ays, costs $ay #eco$e very high, an the actual -roucts or services
-rouce #y the organisation $ay #ear little rese$#lance to the resources
that are involve in the enter-rise"
.11. Business mo(els
In so$e cases a #usiness enter-rise is #ase on a single clear #usiness $oel"
In other situations, a range o+ i++erent activities $ay #e carrie out, an a
range o+ i++erent -roucts or services $ay #e o++ere"
In larger organisations, se-arate internal o-erations $ay e3ist"
2or e3a$-le, an organisation $ay have an internal $anu+acturing o-eration,
an a$inistration area that charges other #usiness units on a contract service
#asis, an a evelo-$ent o-eration that -rouces esigns +or ne! -roucts"
166
2.11.1. /ee for servie
2ee<+or<service involves charging +ees +or -er+or$ing s-eci+ic services"
This is a co$$on #usiness $oel in service inustries, a$ong sole traers
an in -artnershi-s"
In so$e cases +ees are #ase on an hourly rate +or !ork -er+or$e, !hile in
other cases a +i3e +ee a--lies +or s-eci+ic services"
Services $ay #e irectly -er+or$e #y a single iniviual"
In other cases, the task $ay involve a range o+ i++erent -eo-le !ithin an
organisation"
2ee +or service generates a regular cash +lo!"
Although the cash +lo! $ay vary signi+icantly +ro$ ti$e to ti$e, ue to
changing e$an +or services, large in+lo!s an out+lo!s are not -art o+ the
+inancial structure o+ the #usiness"
Businesses o-erating on a +ee +or service #asis can generally aa-t to
changing conitions"
2ee +or service at an hourly rate is not a scala#le #usiness $oel"
Su--lying an increase volu$e o+ services generally involves hiring a larger
nu$#er o+ e$-loyees"
2ee +or service is scala#le in cases !here the +ee is #ase on a -ercentage o+
the transaction si@e, rather than a ti$e<#ase charge"
2.11.2. 3ro(ution an( sale
Manu+acturing o-erates on the #asis o+ -roucing goos +or sale"
This involves -urchasing ra! $aterials, -rouction o+ goos, an sale to
custo$ers"
A !ie range o+ i++erent enter-rises o-erate accoring to this #usiness
$oel, ranging +ro$ han$ae cra+ts to heavy engineering"
200
5rouction an sale re&uires ca-ital to su--ort the -urchase o+ e&ui-$ent,
-rouction +acilities, an ra! $aterials"
These o-erations cannot aa-t easily to -erios o+ lo! sales"
2i3e costs such as #uiling leases an e&ui-$ent e-reciation continue
regarless o+ the level o+ -rouction an sale"
5rouction an sale is a -artially scala#le #usiness $oel"
The +i3e costs o+ -rouct evelo-$ent an +acilities $ay not vary !ith the
level o+ -rouction"
In cases !here a -rouct $eets !ith a high e$an +ro$ custo$ers,
-rouction $ay #e increase #y e3-aning -rouction +acilities, !hile
retaining the original -rouct esign an -rouction $ethos"
2.11.3. 3ro%et (evelopment
5ro9ect evelo-$ent as a #usiness $oel involves $anaging -ro9ects an
evelo-ing large custo$ise ite$s"
This inclues the evelo-$ent o+ co$-uter so+t!are, co$$ercial
construction, an +il$ -rouction"
The -ro9ect $ay #e retaine #y the #usiness, an license to custo$ers on an
ongoing #asis"
In other cases, the -ro9ect is evelo-e +or an e3ternal client"
In the case o+ -ro9ects evelo-e +or clients, -ay$ents $ay inclue -rogress
-ay$ents at various stages o+ the -ro9ect, or a single -ay$ent at the
co$-letion o+ the -ro9ect"
In so$e cases a -ro9ect $ay #e evelo-e internally +or sale, an a custo$er
locate a+ter the -ro9ect is co$-lete"
The !ork itsel+ $ay #e -er+or$e #y e$-loyees o+ the #usiness, or #y
e3ternal contractors"
201
2uning +or the -ro9ect $ay #e #ase on -rogress -ay$ents +ro$ a client,
cash +lo! +ro$ other #usiness o-erations, o+ a su$ o+ ca-ital raise at the
#eginning o+ the -ro9ect"
5ro9ect evelo-$ent re&uires s-ecialist -ro9ect $anage$ent skills"
This #usiness $oel $ay also involve reasona#ly co$-le3 +inancial
$anage$ent, as a -ro9ect $ay involve large negative cash +lo!s at certain
stages an -ositive cash +lo!s at other stages"
In cases !here a -ro9ect is evelo-e internally +or later licensing or sale,
signi+icant levels o+ ca-ital $ay #e re&uire to +un the costs o+ the
evelo-$ent"
2.11.4. +ontrat servies
/ontract services involve -er+or$ing a regular service, rather than
-er+or$ing iniviual services"
This i++ers +ro$ +ee<+or<service, !hich involves se-arate iniviual
transactions"
/ontract co$-uter su--ort an contract a$inistration are e3a$-les o+
#usinesses that o-erate on this #usiness $oel"
5ay$ent $ay #e #ase on a +i3e $onthly +ee, or a +ee #ase on the nu$#er
o+ tasks -er+or$e"
2or e3a$-le, a contract a$inistration service $ay charge +ees #ase on the
nu$#er o+ transactions -rocesse uring a -erio"
/ontract services generate a regular cash +lo! that $ay #e $ore -reicta#le
that an a<hoc +ee<+or<service #asis"
/osts an -rocessing e++iciency $ay #e signi+icant issues !ithin contract
services, as alternative su--liers are generally availa#le, an +ees rates $ay
#e lo! ue to co$-etition !ith other service -roviers"
Also, in $any cases an organisation has the o-tion o+ setting u- internal
services i+ this !oul #e $ore cost<e++ective that using the contract service
-rovier"
202
,arge volu$es are a signi+icant +actor in the success o+ contract service
#usinesses, as this allo!s the +i3e costs o+ the #usiness to #e s-rea across a
larger nu$#er o+ transactions, !hich ena#les +ee rates to #e lo!ere"
This !oul also allo! higher ca-acity e&ui-$ent to #e use, !hich !oul
generally result in a lo!er cost -er ite$"
2.11.5. Development an( liensing
7evelo-$ent an licensing involves creating esigns an artistic !orks"
This inclues +ashion esign, architectural -lans, $usic, an co$-uter chi-
esign"
In so$e cases these esigns are sol, ho!ever in $ost cases they are retaine
#y the evelo-er an license"
The esign $ay #e use +or internal $anu+acturing o+ -roucts, or it $ay #e
license to outsie $anu+acturers"
A #usiness #uilt on this #usiness $oel $ay have a highly unsta#le inco$e"
In $any cases the +inal e$an +or the -rouct cannot #e kno!n, an esigns
an creations that !oul #e e3-ecte to #e success+ul are $et !ith a total
lack o+ interest +ro$ $anu+acturers or the general -u#lic, !hile in other cases
esigns $ay #e une3-ectely success+ul"
Businesses o+ this ty-e re&uire +uning to su--ort the ongoing costs o+
evelo-$ent, !ith revenue #eing un-reicta#le an unsta#le, an revenue
+ro$ -ro9ects not #eing availa#le until the -ro9ect is co$-lete"
2uning $ay co$e +ro$ licence +ees receive +ro$ -revious evelo-$ents,
cash +lo! +ro$ traitional #usiness o-erations, or a ca-ital +un that rises an
+alls !ith changes in inco$e"
In so$e cases, a esign or !ork $ay #e create #y a single iniviual in a
short -erio o+ ti$e"
In other cases, a large -ro9ect $ay #e involve e3tening over several years"
,arge -ro9ect evelo-$ents can #e e3tre$ely e3-ensive"
203
/reating the esign o+ a ne! car, +or e3a$-le, $ay cost over a #illion ollars"
(>> check etails)
This si$-ly relates to the engineering an esign !ork involve in creating
the +inishe technical esign, an oes not involve $anu+acturing or
-rouction"
The evelo-$ent o+ ne! rugs is also an e3tre$ely e3-ensive task, an $ay
take a ecae +ro$ the initial investigations through to actual -rouction"
The costs o+ evelo-$ent such as these are recovere through the inco$e
+ro$ the sale o+ the -rouct itsel+"
This $ay #e $anu+acture #y the #usiness itsel+, or co$e +ro$ license +ees
charge to outsie $anu+acturers"
The costs o+ $anu+acturing a single $eical ta#let or $usic $eia, +or
e3a$-le, is very lo!, !ith the $a9ority o+ the -rice #eing use to recover the
costs o+ creating the esign, rather than the costs o+ ra! $aterials or
-rouction"
2inancial analysis o+ -ro9ects such as these can #e #ase on a net<-resent<
value a--roach"
This $etho co$-ares the ca-ital cost o+ the evelo-$ent !ith the -resent
value o+ the +uture inco$e strea$ +ro$ sales or licence +ees"
2.11.!. /ran.ising
2ranchising is a #usiness $oel that involves the +ranchise #usiness
evelo-ing a range o+ -rouct or services, an a #usiness na$e an -ro+ile,
an licensing ine-enent o-erators to use the #usiness na$e an -roucts"
Inco$e +or the +ranchise #usiness is #ase on +ees +ro$ the ine-enent
o-erators"
The o-erators run an ine-enent #usiness, an -ay a license +ee in e3change
+or the right to use the #usiness na$e, an -urchase the -roucts or -er+or$
the services accoring to the $oel evelo-e #y the +ranchise #usiness"
2ranchising as a #usiness is a scala#le #usiness $oel, an is si$ilar to
licensing $usic or co$-uter so+t!are"
200
2ranchising is $ost a--lica#le to #usinesses that o-erate in a li$ite area,
!ith the sa$e o-eration #eing -er+or$e in a !ie range o+ locations"
%3a$-les inclue ho$e $aintenance services an retail stores"
2.11.7. Diversifie( businesses
7iversi+ie #usinesses are large #usiness enter-rises that inclue a !ie
range o+ i++erent #usiness o-erations !ithin their structure"
This #usiness $oel !as -o-ular uring the 1610Cs"
At the ti$e, the vie! !as that this a--roach !oul reuce the risk o+ the
#usiness o-eration"
Investing in a range o+ i++erent o-erations !oul allo! the #usiness to avoi
serious -ro#le$s i+ a $a9or #usiness unit !as a++ecte #y e3ternal events"
=o!ever, this a--roach !as not -articularly success+ul"
So$e o+ these co$-anies #eca$e very large #y the en o+ the 1610Cs"
By the en o+ the 1660s, ho!ever, $ost ha either colla-se, or ha
graually sol #usiness units over the ecae until there !as little le+t o+ the
original co$-any"
There are t!o $a9or -ro#le$s !ith iversi+ie #usinesses"
The +irst relates to a general -rinci-le o+ iversi+ication"
As the nu$#er o+ iniviual ele$ents gro!, a nu$#er o+ success+ul,
unsuccess+ul, an average results a--ear"
Dith an increase in the nu$#er o+ iniviual co$-onents, the total result
si$-ly #eco$es the average across all inustries, !ithout any sco-e +or the
#usiness to #e a#ove, or #elo!, the average return o+ the econo$y"
Also, the attention an skills o+ the $anage$ent tea$ #eco$e s-rea across
a large nu$#er o+ i++erent activities, an there is little sco-e +or any value to
#e ae to the #usiness o-eration #y the senior $anage$ent o+ the
enter-rise"
20*
Single<-ur-ose co$-anies have #een the success+ul #usiness $oel over the
1660Cs, as these co$-anies can +ocus all their attention on a single ty-e o+
#usiness activity"
=o!ever, the -rinci-le o+ iversi+ication re$ains one o+ the +ounation
-rinci-les o+ +inance"
This a--roach is use in a !ie range o+ areas !ithin #usiness an
invest$ent, +ro$ the structure o+ invest$ent -ort+olios, to the evelo-$ent
o+ $ulti-le -roucts an !ie client #ases"
2.11.8. #ub*leasing
Su#<leasing is use !hen a #usiness o-erates a +acility an leases -arts o+ the
+acility to other #usiness o-erators"
An e3a$-le o+ this !oul #e so$e +ruit an vegeta#le $arkets"
The $arket o-erator !oul o!n or lease the -re$ises, organise -ro$otion
an co<orinate $arket sessions, an then charge a +ee to iniviual
stallholers +or o-erating !ithin the $arket"
This $oel is also use in so$e retail o-erations"
2or e3a$-le, in e-art$ent stores the e$-loyees in $ost areas o+ the
#uiling are e$-loyees o+ the e-art$ent store o-erator"
=o!ever, the e$-loyees !ithin the cos$etics areas are e$-loye #y the
cos$etics houses, not the e-art$ent store, !ith the cos$etics house -aying
+ees +or the use o+ the +loor s-ace !ithin the #uiling"
.1. Structural 1alue
An o-erational #usiness $ay have a value that is higher than the value o+ its
-hysical assets"
In +act, this is usually the case"
This aitional value o+ the #usiness coul #e ter$e the #usinessCs
structural value"
20)
This is the value that has #een create +ro$ the !ay that the #usiness activity
has #een arrange, an +ro$ the !ay that it is $anage"
2or e3a$-le, a service #usiness $ay lease o++ice s-ace an e&ui-$ent, an
coul o-erate, in theory, !ith @ero assets"
%3-enses !oul #e -ai +or rent, $aterials an salaries, !hile inco$e !oul
#e receive +ro$ clients"
I+ the #usiness !as o-erate success+ully, it $ay have a -ositive net inco$e,
an a -ositive value as a #usiness"
=o!ever, there $ay #e +e! -hysical assets o!ne #y the #usiness"
#et operational value
The ter$ :net o-erating value; coul #e use to escri#e the value o+ a
#usiness !hen it is o-erational"
This is the value that !oul #e receive +ro$ selling the #usiness, or -ai #y
the #uyer to -urchase the #usiness"
This inclues the value o+ the #usinessCs net accounting assets, an also the
structural value"
2or e3a$-le
Assets G100
,ia#ilities G30
4et Assets G80 < #alance sheet assets
Structural 'alue G1* < value as a :going concern;
4et A-erational 'alue G1* < value o+ the #usiness
Attri"utes of structural and operational value
The structural an o-erational value o+ a #usiness are not inclue !ithin the
stanar accounting +inancial state$ents"
208
=o!ever, the net o-erational value coul #e esti$ate +ro$ a valuation o+
the #usiness, or the :$arket ca-italisation; o+ a liste co$-any"
The structural value !oul then #e the o-erational value, less the net assets
+ro$ the #alance sheet"
Structural value isa--ears in the case o+ a li&uiation"
Dhen a #usiness ceases to o-erate, the structural value +alls to @ero, an the
value o+ the #usiness #eco$es the li&uiation value o+ the net assets"
The structural value can #e negative"
This occurs in so$e situations, an a--ears in liste co$-anies as a share
-rice that is #elo! the net assets -er share"
This can occur !hen the #usiness is currently o-erating !ith on<going losses,
or assets are not #eing use at all, an investorCs vie!s o+ the #usiness are
that the assets !ill ecline in value in the short or $eiu$ ter$"
The structural value cannot #e sol irectly, ho!ever this value is inclue in
the sale -rice o+ the #usiness i+ the #usiness is sol on an o-erational #asis"
(lements of structural value
The structural value is #ase on a nu$#er o+ issues"
This inclues the collection o+ assets that have #een asse$#le to create the
#usiness enter-rise, an the yna$ic -rocesses that are currently o-erating"
This coul inclue so$e o+ the +ollo!ing ite$s
Static ele$ents
5hysical assets %&ui-$ent, cash #alances
Intangi#le assets 5atents, licences
,ia#ilities 7e#t, other lia#ilities
Arganisation structure
201
/urrent arrange$ents /usto$er su--ly contracts,
su--lier agree$ents
7yna$ic ele$ents
In+lo!s Average ne! custo$ers -er
$onth"
Manage$ent 5rocesses A-eration an $anage$ent
activities
aluation
In the case o+ co$-anies liste on a stock e3change, the net o-erational value
!oul #e e&uivalent to the :$arket ca-italisation; o+ the co$-any, !hich is
the -rice o+ each share $ulti-lie #y the nu$#er o+ shares"
This is the value that the current share -rice i$-lies +or the total value o+ the
#usiness"
Takeovers o+ the co$-any are #ase on this +igure, although in $ost cases a
higher value is o++ere in orer to inuce the $a9ority o+ the shareholers to
agree to sell their shares"
In the case o+ an unliste co$-any, a valuation o+ the #usiness coul #e use
to eter$ine the net o-erational value"
A rule o+ thu$# a--roach coul also #e use"
2or e3a$-le, a $ulti-le coul #e a--lie to the current net -ro+it, such as a
$ulti-le o+ ten ti$es the net -ro+it that $ay #e use to esti$ate a value +or a
reasona#ly sta#le #usiness"
The structural value coul then #e calculate #y eter$ining the i++erence
#et!een the net #alance sheet assets an the total #usiness value"
Anal*sis
Analysis o+ the returns o+ a #usiness $ay use the net o-erating value as a
ca-ital value, rather than the #alance sheet net asset value"
206
The net o-erating value is the e++ective ca-ital value o+ the #usiness, as this is
the value that the #usiness coul #e sol +or"
This is si$ilar to incluing intangi#le assets such as -atents !ithin the value
o+ the #usiness"
In cases !here the o-erational value is #ase on a liste share -rice or an
ine-enent valuation, this value $ay #e use to calculate a rate o+ return
+ro$ the #usiness"
=o!ever, in cases !here the o-erational value itsel+ !as calculate +ro$ the
net -ro+it, this a--roach !oul not #e relevant to calculating a rate o+ return,
as in this case the rate o+ return is an in-ut to the calculation"
Balance sheet structure
The structural value is e-enant on the !ay in !hich the #usiness assets are
hel"
2or e3a$-le, a #usiness that lease $ost assets !oul have a higher
structural value than a #usiness that carrie its assets on the #alance sheet,
although the e++ective value o+ the #usiness structure $ay #e the sa$e"
2or this reason, although structural values $ay #e an i$-ortant issue !ithin
#usiness analysis an evelo-$ent, co$-aring structural value ratios o+
i++erent co$-anies $ay not ienti+y the actual value o+ the #usiness
structures, ue to i++erent #alance sheet structures #eing use"
Ac)uisitions
Dhen a #usiness is -urchase, the structural value is recore on the #alance
sheet o+ the -urchasing co$-any as an intangi#le asset, using the accounting
ter$ :goo!ill;"
This ter$ originally re+erre to the regular custo$ers o+ an esta#lishe
#usiness, !hich gave the #usiness a value a#ove the value o+ its -hysical
assets"
(oo!ill is inclue as an asset on the #alance sheet, an is a$ortise over a
-erio o+ ti$e o!n to @ero"
Hner current Australian accounting stanars, goo!ill $ust #e a$ortise
over a -erio o+ not $ore than t!enty years (>> check)"
210
=o!ever, accounting stanars o not allo! the structural value create
!ithin the #usiness itsel+ to #e recore !ithin the +inancial state$ents"
#egative structural value
A negative structural value occurs !hen a #usiness is o-erating at a loss, !ith
net assets eclining as ti$e goes #y"
This can also occur !hen assets that are locke !ithin a cor-orate structure,
#ut !here no o-erations are currently #eing conucte"
Ather cases inclue situations !here the $arket vie! $ay #e that the
$anage$ent o+ the co$-any $ay $anage the assets -oorly, an -rouce a
negative return"
This can occur, +or e3a$-le, !hen there is an e3cess o+ cash !ithin the
co$-any, an there is a chance that the $anage$ent $ay invest the cash
-oorly in a ne! -ro9ect si$-ly to $ove the #usiness +or!ar"
In these cases, ceasing o-erations !oul lea to an increase in value, as the
negative structural value !as eli$inate"
In so$e cases, a #usiness o!ner $ay !ithra! +ro$ o-erations, an
li&uiate the assets o+ the #usiness"
This occurs in eclining inustries, +or e3a$-le, !here the sales o+ the entire
inustry ecline over ti$e as other inustries #eco$e $ore -o-ular"
4egative structural value also attracts takeovers +ro$ other co$-anies, ue to
the -rice #eing lo! an #eing #elo! the asset value"
This $ay involve an :asset stri--ing; e3ercise, !hen o-erations are close
an the assets are sol, or the assets coul #e integrate into e3isting
o-erations"
.1!. 2ntangible property
Intangi#le -ro-erty inclues any ite$s that the #usiness o!ns that are not
-hysical ite$s"
This inclues -atents, licences, #ran na$es, an esigns"
211
Intangi#le -ro-erty can have signi+icant value"
In the $eia inustry, +or e3a$-le, a large -ro-ortion o+ the assets are the
value o+ television #roacasting licences an ne!s-a-er $astheas"
A ne!s-a-er $asthea is si$-ly the na$e an logo o+ a ne!s-a-er"
The -u#lisher o!ns the rights to use the $asthea, e$-loys sta++ such as
9ournalists an eitors, #uys stories +ro$ ne!s services, an -rints the
ne!s-a-er itsel+"
The value o+ the ne!s-a-er $asthea itsel+ can #e very high"
2or e3a$-le, i+ the sa$e -rocess !as +ollo!e +or a ne! ne!s-a-er that !as
not !ell kno!n, sales $ay #e lo!, even through the contents o+ the
ne!s-a-er $ay #e the sa$e"
4e! ne!s-a-er titles an other $eia titles a--ear rarely, ue to issues such
as the large ca-ital cost o+ high ca-acity -rinting -resses, costs involve in
-roucing the content, an istri#ution arrange$ents !ith istri#utors"
2.13.1. T$pes of intangible propert$
Intangi#le -ro-erty +alls into several categories"
These inclue the +ollo!ing"
2.13.1.1.'bstrat items
A#stract ite$s are esigns an ite$s that e3ist se-arately +ro$ their recore
+or$"
This inclues $usic, +il$, an co$-uter so+t!are"
A#stract ite$s $ay #e covere #y -atents, in the case o+ invente -rocesses,
or co-yright, in the case o+ artistic an creative !orks"
These ite$s !oul generally #e inclue in the +inancial state$ents uner
heaings such as -atents, or co-yrighte !orks"
212
Patents & cop*right
5atents a--ly to o!nershi- o+ an invention, such as a ne! $anu+acturing
techni&ue, or a $eical rug"
Artistic an creative !orks are governe #y co-yright, !hile invente
-rocesses are governe #y -atents"
/o-yright e3ists as soon as a !ork is create, !hile -atents over inventions
$ust #e grante #y the -atents o++ice #e+ore they take e++ect"
The result is si$ilar in each case, !ith the o!ner o+ the ite$ having the right
to -rouce the ite$ or licence other -arties to -rouce it, !ithout the esign
#eing co-ie !ithout their consent"
-rade marks & "rand names
Trae $arks an #ran na$es are gra-hical logos an escri-tions that
ienti+y a -rouct"
In the case o+ !ell<kno!n #ran na$es, these $ay have signi+icant value"
Trae $arks an #ran na$es $ust #e registere #e+ore legal action coul #e
taken to -revent other $anu+acturers +ro$ co-ying the #ran na$e or trae
$ark"
2.13.1.2.8ienes to operate
,icences involve licences to -er+or$ certain activities, such as television
#roacasting licences"
This i++ers +ro$ licences to use a#stract -ro-erty, such as a licence to use a
-atente -rocess !ithin a $anu+acturing -rocess"
In the case o+ licenses to $anu+acture -roucts an -er+or$ services using
esigns o!ne #y other -arties, licences o+ this ty-e are not usually recore
in the #alance sheet"
2.13.1.3.1oo(5ill
213
(oo!ill is recore as an intangi#le asset !hen a #usiness is -urchase +or
a -rice that is a#ove its net asset value"
This is a$ortise over a -erio o+ ti$e"
A$ortisation is si$ilar to e-reciation o+ -hysical ite$s"
An e3-ense is recore in each -erio to re+lect the reuction in value, an
the value o+ the asset in the #alance sheet is reuce"
2.13.2. :aluations
'aluing intangi#le -ro-erty can #e i++icult"
In $any cases there is no si$ilar -ro-erty that can #e co$-are to the ite$ to
eter$ine a $arket value"
In so$e cases, an intangi#le asset cannot #e sol, an so oes not have a
$arket value"
2or e3a$-le, the #ran na$e o+ the #usiness o-eration itsel+, rather than a
se-arately $aintaine #ran na$e, cannot #e sol ine-enently o+ the
#usiness"
The value o+ the -ro-erty to the #usiness is #ase on the inco$e that coul #e
generate +ro$ o!ning the -ro-erty"
In cases such as -atents an #ran na$es, this $ay #e i++icult to esti$ate,
an $ay vary !iely e-ening on i++erent circu$stances"
'aluation o+ intangi#le -ro-erty can #e -er+or$e #y valuation +ir$s"
2or e3a$-le, a large $arket research agency $ay -er+or$ a valuation o+ a
#ran na$e, +or the -ur-ose o+ listing the #ran na$e as an asset in the
#alance sheet"
1perational vs! /arket alue
5hysical assets are generally liste in the #alance sheet at their #ook value,
!hich is their cost -rice less e-reciation"
Ather assets are liste at their value to the #usiness as an o-erating enter-rise"
210
This $ay #e &uite i++erent +ro$ their $arket value or li&uiation value,
-articularly in the case o+ intangi#le assets"
A -atent o+ a s-ecialise -rouction -rocess, +or e3a$-le, $ay have
signi+icant value to the #usiness, #ut $ay have little or no value i+ o++ere +or
sale"
In the case o+ li&uiation, these assets shoul o+ten #e ignore +or the
-ur-oses o+ esti$ating the +uns that can #e raise +ro$ asset sales"
2or e3a$-le, goo!ill on ac&uisitions cannot #e sol an has no value in a
li&uiation"
(oo!ill also has &uestiona#le value to the +uture #usiness o-erations, an in
so$e cases a $ore relia#le analysis !oul involve !riting o++ the goo!ill
-rice in the current year as a cost o+ -urchasing the other #usiness"
,i&uiation value $ay arise in $anaging a +inancial istress situation, or in
assessing the +inancial -osition o+ a co$-any +ro$ the -ers-ective o+ an
investor or lener"
Conservative valuations
The value o+ an intangi#le asset can vary !iely e-ening on the o-inion o+
the valuer, the use to !hich the asset is -ut, an traing conitions !ithin the
#usiness"
,arge !rite<o!ns o+ intangi#le asset valuations can occur !hen the asset is
re<value"
This can #e a cause o+ $a9or -ro#le$s +or the co$-any, as the asset values
+all signi+icantly, an raising or rolling over e#t $ay #eco$e i++icult"
Also, a #usiness $ay -rocee !ith an overly a$#itious e3-ansion -rogra$, i+
the value that is -lace on intangi#le assets is unrealistically high"
These -ro#le$s $ay #e reuce i+ intangi#le assets are value
conservatively, !ith #alance sheet valuations using a #ase +igure, rather than
an o-ti$istic +igure"
21*
2.13.3. 'bstrat items
A#stract ite$s are ite$s o+ -ro-erty that have a se-arate e3istence +ro$ their
-hysical +or$"
2or e3a$-le, a -iece o+ $usic $ay #e !ritten as a -age o+ notes or #roacast
through a live -er+or$ance"
In each case, the -hysical +or$ is i++erent"
=o!ever the $usic itsel+ is the sa$e co$-osition in #oth cases"
This e3a$-le illustrates that the $usic has a se-arate e3istence +ro$ the
-hysical +or$, such as the sheet $usic or a soun recoring"
This is also kno!n as intellectual -ro-erty"
The +ollo!ing ite$s are a#stract ite$sE
Music
2il$s
Books
/o$-uter so+t!are
Meical rugs (che$ical +or$ula)
5rouct esigns
Manu+acturing -rocesses
7esigns such as architectural ra!ings
In the case o+ a #ook, as another e3a$-le, a #ook coul #e -rinte on -a-er
or s-oken as a recore $essage, an the te3t !oul #e the sa$e in each
case"
In the case o+ ite$s such as -rouct esigns, these $ay not have a large value
unless they can #e -atente"
Success+ul ne! +eatures o+ -roucts !oul generally #e ae to co$-etitors
-roucts as ti$e !ent #y"
21)
A#stract -ro-erty oes not inclue #ran na$es, licences to o-erate
activities, an other intangi#le -ro-erty that oes not involve a create esign
that is se-arate +ro$ its -hysical +or$"
So$e ite$s o+ a#stract -ro-erty are use o+ their o!n accor, such as artistic
!orks, !hile other ite$s are use as a #asis +or other activities, such as
$anu+acturing -rocesses an architectural ra!ings"
2.13.3.1.#ale vs. 8iensing
As !ith other ty-es o+ -ro-erty, a#stract -ro-erty can #e #ought an sol"
The co-yright to a creative !ork coul #e sol to another -arty, !hile a
-atent over a -articular -rocess coul also #e #ought or sol"
=o!ever, a#stract -ro-erty has an aitional +eature that is uni&ue in
co$-arison to -hysical ite$s"
A -hysical ite$ can only #e hel #y a single -erson at any given ti$e"
Selling an ite$ involves giving u- the ite$ in return +or a -ay$ent"
The ite$ is lost, an the -ay$ent is receive"
=o!ever, !hile a#stract -ro-erty can also #e sol or loane, it can also #e
license"
This allo!s other -arties to use the esign or ite$, in return +or a licence +ee"
The -urchase o+ a $usic isk, +or e3a$-le, involves the -urchase o+ the
-hysical isk, an also the -urchase o+ a licence +or the right to -lay the
$usic"
,icences can #e grante to $ulti-le -arties at the sa$e ti$e"
Dhen a ne! licence is grante, the original ite$ is not lost"
218
2.13.3.2.3ro(ution
4or$al $anu+acturing an -rouction issues are involve in the -rouction
o+ the -hysical $eia, such as a co$-uter isk use to store a so+t!are
-rogra$"
Ather e3a$-les inclue the -rouction o+ $eical ta#lets"
In $ost cases the cost o+ the $eia itsel+ an the -rouction -rocess is very
lo!"
The $a9ority o+ the cost a--lies to the licence +ee, rather than ra! $aterials
or -rouction costs"
The licence +ee is then use to recover the costs o+ evelo-ing the esign or
ite$"
2.13.3.3.+ontinuous vs. 3ro%et*base( pro(ution
Manu+acturing an service #usinesses o-erate on a continuous #asis"
Inco$e is accu$ulate continuously, !ith the total value o+ the #usinessCs
assets rising or +alling !ith changing o-erating conitions"
A#stract -ro-erty evelo-$ent involves iniviual transactions"
This is +una$entally a -ro9ect<#ase e3ercise, rather than a continuous
-rouction e3ercise"
A -ro9ect $ay #e evelo-e, sol, an then another -ro9ect co$$ences"
,arge organisations $ay o-erate several -ro9ects at the sa$e ti$e"
In the case o+ s$aller enter-rises, a single -ro9ect $ay #e evelo-e at a
ti$e"
/o$-uter so+t!are is evelo-e in this !ay, +or e3a$-le"
In contrast to continuous -rouction, -ro9ect evelo-$ent involves large
i++erences in cash +lo!s at i++erent -oints in ti$e"
The evelo-$ent -hase $ay involve negative cash +lo!, !ith e3-enses #eing
-ai an no inco$e #eing receive"
211
The -rouction or licensing -hase $ay then involve -ositive cash +lo!, !ith
inco$e #eing receive an e3-enses #eing lo!"
The evelo-$ent -hase generally involves a -erio o+ ti$e ranging +ro$
several $onths to several years in length"
The -rouction -hase $ay last as little as a +e! !eeks, in the case o+ $usic
an +il$, through to ecaes in the case o+ $eical evelo-$ents"
The +ollo!ing set o+ cash +lo!s illustrates this i++erence #et!een continuous
activities an -ro9ect<#ase activities"
216
Continuous Pro2ect Based
(%penses ,ncome (%penses ,ncome
100 120 0 0
100 120 0 0
100 120 0 0
100 120 100 0
100 120 100 0
100 120 100 0
100 120 100 0
100 120 100 0
100 120 100 0
100 120 100 0
100 120 0 100
100 120 0 200
100 120 0 300
100 120 0 300
100 120 0 200
100 120 0 200
100 120 0 100
100 120 0 *0
100 120 0 *0
100 120 0 *0
100 120 0 0
100 120 0 0
100 120 0 0
220
2.13.3.4.3rofitabilit$
7evelo-ing an licensing a#stract -ro-erty involves several issues"
Signi+icant ca-ital $ay #e re&uire to +un the initial e3-enses"
Also, the -ro+ita#ility o+ the total -rocess $ay #e #ase on a total set o+
events that have occurre over $any years"
In contrast, the -ro+ita#ility o+ a $anu+acturing or service #usiness can #e
eter$ine on a $onth<to<$onth #asis, ignoring -ast an +uture events"
2.13.3.5.8everage
A#stract -rouction is a highly leverage e3ercise"
A -oorly -er+or$ing -rouct $ay result in a large loss, !hile a success+ul
-rouct $ay generate a large in+lo! o+ +uns"
2il$ stuios, +or e3a$-le, have highly unsta#le inco$e an -ro+it, ue to the
+act that iniviual +il$s $ay #e highly success+ul or generate large losses"
2.13.3.!.:aluations
'aluing a continuous -rocess can #e one using $ulti-les o+ the current
inco$e, the assets o+ the enter-rise, an co$-arisons !ith other sales"
'aluing a -ro9ect #ase activity is $ore co$-le3"
This involves revie!ing the +ull set o+ cash +lo!s, +ro$ the co$$ence$ent
o+ the -ro9ect, to the +inal inco$e that is receive #e+ore the value o+ the ite$
+alls to @ero"
In situations !here the entire li+e cycle occurs !ithin a -erio o+ a +e! years,
cash +lo!s can #e ae an su#tracte"
2or e3a$-le, valuing a +il$ -rouction $ay involve calculating the total
e3-enses, an aing an esti$ate o+ the average inco$e that the -ro9ect $ay
-rouce"
221
Dhen the +uture sales $ay e3ten over a -erio o+ $ore than t!o or three
years, a +ull net<-resent<value calculation !oul #e re&uire to eter$ine the
e++ective value o+ the #usiness or the -ro9ect"
This a--roach is use in valuing li+e insurance co$-anies, +or e3a$-le,
!here -olicies $ay involve cash +lo!s long into the +uture"
This -rocess involves calculating a -resent value o+ a +uture cash +lo!"
2or e3a$-le, an inco$e a$ount o+ G100 to #e receive +ro$ a -ro9ect in
three yearCs ti$e $ay only #e !orth an e&uivalent o+ G12 at the current ate"
This occurs #ecause the G12 coul #e investe over the three year -erio, an
$ay gro! !ith interest to #e e&uivalent to the G100 a$ount in three yearCs
ti$e"
The -resent values o+ each inco$e an e3-ense -ay$ent $ay #e calculate,
an ae together to eter$ine a total value +or a -ro9ect"
The calculations that $ay #e involve in this -rocess are escri#e in the
section on +inance, #eginning on -age 820"
222
The +ollo!ing e3a$-le lists a set o+ esti$ate cash +lo!s +ro$ a -ro9ect, the
-resent value o+ each cash +lo!, an the total esti$ate -ro9ect value"
;ear +as. 3resent
/lo5 :alue
1 *1"" *1""
2 *1"" *89
3 *1"" *8"
4 8" 57
5 8" 51
! 8" 45
7 8" 41
8 8" 3!
9 8" 32
1" 8" 29
11 8" 2!
12 8" 23
13 8" 21
14 8" 18
15 8" 1!
1! 8" 15
Total 3ro%et :alue 141
The -ro9ect value is the su$ o+ the -resent value o+ each o+ the iniviual
cash +lo!s, incluing e3-enses an inco$e"
In this e3a$-le, the -resent value o+ the cash +lo!s su$s to a net value o+
G101 at the current ate"
2uture inco$e a$ounts are o+ten not kno!n, an an esti$ate $ust #e $ae
o+ average likely inco$e"
A -resent value is calculate using a iscount rate"
A iscount rate is si$ilar to the interest rate that coul #e receive +ro$
investing early cash +lo!s in the -ro9ect"
223
A iscount rate $ay #e eter$ine +ro$ current interest rates, an aing an
aitional a$ount to the iscount rate, kno!n as a risk -re$iu$"
The risk -re$iu$ reuces the -resent value o+ a cash +lo! to re+lect the risk
or volatility involve in the cash +lo!"
In cases !here the cash +lo!s coul #e esti$ate !ith reasona#le accuracy,
such as a -ro-erty invest$ent, toll roas, or a evelo-$ent +or a client, a lo!
risk -re$iu$ $ay #e ae to current interest rates"
In cases o+ highly uncertain inco$e, such as +il$ an $usic -rouction, a
higher risk -re$iu$ $ay #e ae"
Risk -re$iu$s !oul co$$only vary +ro$ 2L to 1*L, so that the total
iscount rate $ay vary +ro$ 10L to 23L i+ #ase interest rates !ere currently
aroun 1L"
The net -resent value is the value o+ the -ro9ect, an this is the a$ount that
!oul #e -ai #y another -arty to take over the e3-enses an inco$e o+ the
-ro9ect"
The sa$e a--roach can #e use to value a #usiness itsel+, in aition to
valuing iniviual -ro9ects"
2.13.3.7.Disonnetion bet5een prie & ost
In the case o+ continuous -rouction, such as $anu+acturing an services,
each ite$ -rouce has a cost an a sale -rice"
2or e3a$-le, -roucing an ite$ $ay involve cost o+ G10"
Dith a sale -rice o+ G12, this !oul result in a net -ro+it o+ G2 -er ite$"
In the case o+ licensing, ho!ever, this relationshi- #et!een costs an sale
-rices #reaks o!n"
In a licensing evelo-$ent, the costs are a single +i3e ollar a$ount, an are
not relate to the nu$#er o+ ite$s -rouce"
Also, in the -ure sense o+ licensing, the inco$e +ro$ each ite$ +lo!s irectly
into the #usiness"
220
In theory, any sale -rice at all !oul result in a -ro+it +ro$ the iniviual
transaction"
In -ractice, so$e $anu+acturing an istri#ution costs are involve"
An overall -ro+it !oul #e recore i+ the nu$#er o+ sales !as high enough
to recover the evelo-$ent costs"
This situation can #e su$$arise in the +ollo!ing +or$ulasE
5rouction (-ro+it -er -erio)
( ) period per t cos fixed units of number unit per t cos unit per price profit
,icensing (-ro+it since -ro9ect co$$ence$ent)
t cos t developmen total units of number unit per price sale profit
This isconnection #et!een costs an sale -rices has a nu$#er o+
i$-lications"
Setting prices
In the case o+ -rouction, the sale -rice is set !ithin a narro! range #y the
cost o+ -rouction"
I+ the sale -rice is #elo! the cost o+ -rouction, sales !ill generate a loss
rather than a -ro+it, an the #usiness $ust either cease -rouction, alter the
current situation, or net assets !ill eventually ecline to @ero an the #usiness
!ill close"
I+ the sale -rice is signi+icantly a#ove the cost o+ -rouction, strong cash
in+lo!s -er ite$ !ill #e recore"
=o!ever, in this situation, the nu$#er o+ sales $ay #e lo!, or co$-etitors
$ay #e attracte to the $arket an o++er lo!er -rices"
In the case o+ licensing, there is no re+erence -oint in eter$ining the sale
-rice"
22*
By e+inition, license ite$s are generally i++erent +ro$ the ite$s availa#le
+ro$ co$-etitors"
In -ractice a #roa -rice range is usually eter$ine #y $arket interest in the
-rouct"
=o!ever, alternative -roucts that have si$ilar +eatures $ay vary !iely in
-rice"
/ultiple versions
This situation also allo!s +or the sa$e unerlying -rouct to #e sol in
i++erent !ays"
2or e3a$-le, a co$-uter chi- coul #e esigne an $anu+acture +or use
!ithin han<hel calculators"
T!o versions o+ the calculator coul #e -rouce using the sa$e chi-, one
!ith #asic +eatures at a lo! -rice, an another !ith avance +eatures at a
higher -rice"
At +irst thought, it $ay see$ strange to sell the calculator har!are at a lo!
-rice, !hen the sa$e ite$ coul also #e sol at a higher -rice"
=o!ever, there is an unerlying $arket e$an +or lo!<cost #asic
calculators, an also a $arket e$an +or higher -rice calculators !ith
avance +eatures"
Assu$ing that the $a9or cost involve !as the esign -rocess +or the chi-
itsel+, rather than -rouction, the cost o+ -roucing iniviual ite$s $ay #e
lo!"
This arrange$ent $ay have lo!er costs than organising t!o se-arate esign
-ro9ects"
By o++ering t!o versions o+ the -rouct, the total nu$#er o+ sales o+ the chi-
$ay #e increase"
A si$ilar arrange$ent is so$eti$es use !ith i++erent versions o+ co$-uter
-rogra$s"
22)
This $arketing a--roach !as trie in the -ersonal co$-uter so+t!are $arket
uring the early 1660Cs, although it !as not -articularly success+ul, !ith sales
o+ the reuce versions #eing lo!"
228
!. Developing a business
!.1. Developing a business
7evelo-ing a #usiness re&uires three +una$ental ste-s
1" /reating a -rouct or service that is attractive to custo$ers"
2" 7elivering the -rouct at a -rice that is co$-etitive !ith other
-roucts, an is lo! enough that custo$ers !oul choose to
-urchase the -rouct"
3" Averco$ing #arriers cause #y close $arkets, e3isting long<ter$
agree$ents, an i++iculty !ith $arketing an co$$unicating !ith
-otential custo$ers
The +irst stage involves the conce-t an ieas #ehin the #usiness venture"
This !oul lea to the esign an evelo-$ent o+ actual -roucts or services"
In a start<u- enter-rise, an initial stage o+ iscussion !ith -otential
custo$ers, evelo-$ent o+ ieas an -roucing sa$-le -roucts or esigns
$ay #e involve in the early stages o+ the enter-rise"
The secon stage involves the e++ective o-eration o+ the #usiness"
Initially this $ay involve hiring e$-loyees, sourcing ra! $aterials +ro$
su--liers, -urchasing e&ui-$ent an creating -rocesses an o-erational
-lans"
Angoing $anage$ent $ay involve revie!ing an $anaging costs, u-ating
e&ui-$ent an -rocesses, an $anaging the cash +lo! an ca-ital o-erations
o+ the #usiness"
5roucts have a li$ite li+e cycle an the esign an evelo-$ent o+ ne!
-roucts $ay #e re&uire +ro$ ti$e to ti$e to continue the long ter$
o-eration o+ the #usiness"
The thir stage involves generating sales o+ -roucts"
Although a -rouct $ay #e -rouce an o++ere at an attractive -rice, sales
$ay not occur +or $any reasons"
221
In $any !holesale $arkets, e3isting long<ter$ arrange$ents #et!een
custo$ers an su--liers $ay #e a signi+icant #arrier to the generation o+ sales
#y a ne! #usiness"
This is a long<ter$ issue an is not overco$e #y a single a--roach"
=o!ever, various ste-s can #e taken"
2ree sa$-les an e$onstrations can #e given to +a$iliarise -otential
custo$ers !ith the -rouct"
In $any cases, the issues that are #ehin a custo$erCs -urchasing ecisions
$ay #e &uite i++erent +ro$ the issues that !oul #e initially i$agine"
2or e3a$-le, -rice an &uality are usually $a9or issues"
=o!ever, the relia#ility o+ su--ly is also o+ critical i$-ortance"
%s-ecially in the case o+ ne! #usinesses, esta#lishing the case that a -rouct
can #e su--lie in the re&uire volu$es on a relia#le #asis $ay #e highly
i$-ortant"
In the retail $arket involving sales to the general -u#lic, -ro$otion $ay #e
#ase on avertising, arrange$ents !ith istri#utors to carry the -rouct, an
an initial -erio o+ lo!<cost services to esta#lish a -resence !ithin the
$arket"
7evelo-$ent o+ the #usiness over the long ter$ $ay involve gro!th an
change in the nature o+ the #usiness"
In so$e cases a #usiness is esta#lishe !ith a clear an irect o-eration, +ills
a s-eci+ic +unction !ithin a $arket, an o-erates +or a long -erio o+ ti$e
!ith little change"
A !holesale istri#utor o+ +ruit an vegeta#les +ro$ gro!ers to retailers $ay
#e an e3a$-le o+ this situation"
In other cases, a #usiness $ay continually evolve over ti$e"
It $ay change +ro$ a $anu+acturing #usiness to a service #usiness, or +ro$ a
service #usiness to a $anu+acturing #usiness"
4e! areas o+ the #usiness $ay evelo-, !hile others $ay close"
The #usiness $ay gro! in si@e, or it $ay ecline"
226
A #usiness that co$$ence in one inustry $ay eventually $ove to a
se-arate inustry, either in a single 9u$- or graually over ti$e"
The econo$y changes continuously, !ith so$e inustries eclining an ne!
gro!th inustries a--earing"
!.. ,voi(ing (isaster
Businesses can colla-se sur-risingly ra-ily"
In so$e cases, a #usiness that a--eare to #e o-erating s$oothly can strike
several i++iculties an its +inancial -osition can eteriorate !ithin a $atter o+
$onths, leaing to li&uiation or a #reak<u- o+ the #usiness"
So$e ste-s can #e taken to reuce the changes o+ serious -ro#le$s occurring
!hen they are least e3-ecte"
Cash flow
/ash +lo! -ro#le$s can occur !hen sales are slo!, or !hen several large
in+lo!s are elaye +or one reason or another"
/ash +lo! -ro#le$s can also occur uring -erios o+ high sales"
In these cases, a large nu$#er o+ ra! $aterials $ay nee to #e -urchase, or
aitional !ork -er+or$e to $eet a high level o+ custo$er orers, although
the inco$e +ro$ the sales $ay not co$e through +or an e3tene -erio o+
ti$e"
/ash +lo! -ro#le$s can #e reuce #y ensuring that an ae&uate level o+
!orking ca-ital is availa#le"
This inclues cash #alances hel in #ank accounts, an unuse availa#le
creit through overra+ts an other creit +acilities"
De"t & negative cash flow
=igh e#t levels $ay -lace a #usiness in a vulnera#le -osition"
230
Dhen interest costs are a large -art o+ net inco$e, a s$all ecrease in
revenue or a s$all increase in e3-enses $ay change the net cash +lo! +ro$ a
-ositive to a negative value"
4egative cash +lo! occurs !hen the cash that is +lo!ing out o+ the #usiness
in e3-enses occurs at a greater rate than the cash that is +lo!ing into the
#usiness +ro$ inco$e"
4egative cash +lo! is an unsustaina#le situation, as the net assets !ill
eventually +all to @ero, leaing to the closure o+ the #usiness"
=igh e#t levels $ay #e use +or a -erio o+ ti$e in cases !here revenue an
e3-enses are very sta#le, ho!ever as a general rule a #usiness is -lace in a
$ore secure -osition #y reucing the level o+ e#t"
The level o+ a--ro-riate e#t varies consiera#ly !ith the inustry an ty-e
o+ o-eration"
=o!ever, a level o+ *0L e#t an *0L e&uity is a co$$on #ench$ark"
2or e3a$-le, a #usiness $ay have total assets o+ G100, e#ts o+ G*0, !ith the
net assets #eing G*0"
7e#t levels a#ove *0L o+ assets $ay re-resent a risk to the #usiness i+
o-erating conitions eteriorate"
7e#t levels can also #e revie!e #y calculating the -ercentage o+ net cash
+lo! that is use to $eet interest -ay$ents"
Dhen interest costs e3cee aroun 20L o+ net cash +lo!, this $ay signal that
the interest #uren re-resents a -ossi#le anger to the survival o+ the
#usiness"
7e#t levels can #e reuce #y raising aitional e&uity +uns +ro$ investors,
irecting cash +lo! to re-aying e#t rather that -aying iviens, an selling
unuse assets to re-ay e#t"
Reucing e#t levels generally nees to #e one as soon as the -ro#le$
#eco$es a--arent"
I+ o-eration continues an -ro#le$s later occur, it is generally too late at that
ti$e to i$-le$ent the e#t<reuction -rocesses"
231
3igh growth rates
=igh gro!th rates $ay -resent a anger to #usiness survival"
Although this is generally a -ositive evelo-$ent, !hen a high gro!th rate
occurs it $ust #e care+ully $anage"
A co$-any can e3haust its ca-ital resources very &uickly uring a high
gro!th -hase, as ne! e&ui-$ent is -urchase, ra! $aterial su--lies are
increase an -ay$ents to e$-loyees an contractors rise ra$atically to
$eet custo$er orers"
In these cases the #usiness $ay #eco$e insolvent an #e li&uiate ue to
having insu++icient ca-ital to $eet e3-enses an continue o-eration"
Assets
Assets that co$-rise a signi+icant -ro-ortion o+ the #usiness assets, or that
are essential to #usiness o-eration, can #e insure in $any cases"
This inclues #uilings an e&ui-$ent"
Asset shoul generally #e value at conservative levels"
This -articularly a--lies to intangi#le assets such as #ran na$es"
'aluing assets at reasona#le levels $ay #e i$-ortant in $aintaining the
creit rating o+ the co$-any, i+ any, an the a#ility o+ the co$-any to raise
+uns through e#t or e&uity"
A cor-orate revie! that results in a severe o!n!ar valuation in a large
asset can shatter the #alance o+ the +inancial structure o+ the organisation, an
in so$e cases $ay lea to colla-se o+ a #usiness"
!.!. 3lans vs. Directions
,ong ter$ -lans can o $ore har$ than goo"
,ong ter$ -lans $ay lock the #usiness into a +i3e !ay o+ thinking that
-revents it +ro$ a9uste to changes in circu$stances as ti$e -asses"
5lans rely on $aking assu$-tions a#out events that !ill occur in the +uture"
232
In these events o not occur, the #usiness $ay su++er consiera#le loss"
Also, actions that are taken early in a -lanning -erio $ay $ean that the
actions in the later -art o+ the -lanning -erio have to #e +ollo!e through,
even i+ change conitions !oul $ake this un+avoura#le +or the #usiness"
5lans involve intentions to take s-eci+ic actions on s-eci+ic +uture ates"
5lans also involve assu$-tions a#out actions that !ill #e taken #y other
iniviuals in the +uture, that the #usiness has no control over"
2or e3a$-le, #ugets an targets o+ten inclue re+erences to a +i3e nu$#er
o+ sales in a +uture -erio"
=o!ever, the ecision to -urchase an ite$ is $ae #y the custo$er, not the
#usiness"
A #usiness coul -lan to -urchase an ite$ o+ e&ui-$ent, +or e3a$-le, #ut it
cannot -lan to sell a s-eci+ie nu$#er o+ ite$s i+ custo$ers si$-ly ecline to
-urchase the #usinessCs -roucts"
This illustrates a general issue that -lans can only #e $ae +or actions that
the #usiness -er+or$s, a -lan cannot #e $ae a#out actions that ine-enent
-arties !ill -er+or$"
An alternative a--roach to $aking long ter$ -lans is to set +uture irections"
=o!ever, so$e #usiness also o-erate !ithout an -lans or a consistent
irection"
Transactions $ay occur at rano$, !ith transactions #eing conucte as the
o--ortunity arises, an !ithout any consistent a--roach or -ractical irection
+or the #usinesses"
Businesses o-erate on this #asis rarely gro! over the long ter$, an $any
#usiness +ailures are characterise #y an a--roach that involve rano$
transactions rather than a clear +uture irection"
Setting +uture irections involves -er+or$ing the current actions o+ the
#usiness in a consistent !ay, so that the #usiness $ay evelo- in a -articular
irection"
This involves a +le3i#le a--roach that can aa-t to changing conitions"
233
=o!ever, a irection<#ase a--roach still involves consiering the -ossi#le
!ays that events $ay un+ol, an consiering +uture actions that $ay #e
availa#le as this ha--ens"
A irection #ase a--roach oes not involve -lanning s-eci+ic actions on
s-eci+ic +uture ates, an it oes not involve $aking assu$-tions a#out
+uture actions #y other -arties"
This +ollo!ing e3a$-le co$-ares a -lan<#ase a--roach an a irection<
#ase a--roach to consiering the +uture evelo-$ent o+ a #usiness"
5lan
Sell 100 ite$s ne3t year"
Sell 200 ite$s in the secon year"
Reach #reak<even cash +lo! in the thir year"
7evelo- -rouct ? in the thir year"
Sell 100 units o+ -rouct ? in the +ourth year"
A-en #ranch o++ice in the +ourth year"
A-en a secon #ranch o++ice in the +i+th year"
7irection
2ocus current e++orts on increasing sales"
Reach cash +lo! #reak<even in the $eiu$ ter$, -ossi#ly the thir
year"
7evelo- -rouct ? a+ter cash +lo! #reak<even is reache"
A-en #ranch o++ice a+ter evelo-ing -rouct ?, -ossi#ly in the
+ourth year"
I+ the +irst #ranch o++ice is success+ul, o-en a secon #ranch o++ice
in the +ollo!ing year"
A irection<#ase a--roach is not less rigorous or etaile than a -lan<#ase
a--roach"
This $ay involve the sa$e or $ore thought an consieration than an
a--roach #ase on setting s-eci+ic -lans"
A irection #ase a--roach avois $aking assu$-tions a#out +uture events"
This is ue to the +act that $any -ossi#le events coul occur, !hile -lans
generally assu$e that a single course o+ events !ill un+ol"
230
Also, the irection<#ase a--roach allo!s +or varia#le ti$e +ra$es, an
consiers taking +uture actions a+ter an earlier conition has #een reache,
rather than at a certain +i3e ate"
The irection<#ase a--roach also allo!s +or the -ossi#ility that so$e evens
$ay or $ay not occur, such as a -rouct #eing success+ul or unsuccess+ul, in
contrast to a -lan<#ase a--roach that generally assu$es that a +i3e set o+
events !ill occur on +uture ates"
In the case o+ -ro9ects, ho!ever, the o--osite situation occurs"
A -ro9ect $ust generally #e -lanne care+ully, !ith a +i3e set o+ tasks,
ti$e+ra$es an events, in orer to #e co$-lete success+ully"
5ro9ect $anage$ent involves co<orinating the activities o+ the -ro9ect
accoring to the scheule, an $aking changes to the -ro9ect activities as
events un+ol to ensure that the -ro9ect is +ollo!e through to co$-letion"
5ro9ects that o-erate on the #asis o+ evelo-ing general irections, rather than
co$-leting a s-eci+ic evelo-$ent #y a +uture ate, can #eco$e a -er$anent
rain on the cash +lo! o+ the #usiness an $ay never -rouce any su#stantial
co$-lete results"
!.". *ecor(s an( information
Accurate an u-<to<ate in+or$ation is essential to $anaging a #usiness
o-eration"
This a--lies to all co$$ercial activity, +ro$ selling han$ae cra+ts at a
cra+t $arket, to glo#al $ultinational enter-rises"
Many #usiness +ailures are associate !ith -oor recor kee-ing an access to
in+or$ation, incluing large cor-orate colla-ses"
In so$e cases, -articularly cor-orate enter-rises an $anu+acturing, large
volu$es o+ co$-le3 re-orts an in+or$ation $ay #e -rouce"
=o!ever, only a +e! key ite$s $ay #e necessary to check the $a9or issues
involve in an o-eration"
This $ay inclue the tren in sales, the tren in e3-enses, an the availa#ility
o+ cash #alances to $eet $a9or short<ter$ cash +lo! -ro#le$s"
23*
Small (nterprises
The essential +inancial recors +or a s$all or $eiu$ si@e enter-rise can #e
su$$e u- in the +ollo!ing listE
/ash #alances in #ank accounts"
Inco$e +or the -erio"
%3-enses +or the -erio"
A$ounts currently ue +or -ay$ent, or ue !ithin a short -erio"
Inco$e an e3-enses $ay #e recore on a !eekly or $onthly #asis, an a
tren over the -revious $onths $ay also #e recore"
A aily cash #ook is generally ke-t #y #usinesses that o-erate !ith -hysical
cash"
Accounting recors $ay #e reconcile against #ank state$ents on a $onthly
#asis"
Ather recors that $ay #e neee inclue lists o+ stock on han, !hich can
#e checke through $anual stock counts on a -erioic #asis"
Larger enterprises
2inancial recors +or larger enter-rises are generally co$-ile on a $onthly
#asis"
This $ay inclue a range o+ in+or$ation, such as so$e o+ the +ollo!ing ite$s
Inco$e, allocate #y category such as -rouct ty-e"
%3-enses, allocate #y category"
/a-ital ite$s such as asset -urchases an sales"
23)
Actual +igures $ay #e re-orte, along !ith +igures +or #ugete targets, year<
to<ate totals, an co$-arisons !ith the sa$e -erio last year"
4on<+inancial recors a--ly to $any #usinesses an $ay inclue so$e o+ the
+ollo!ing in+or$ationE
The nu$#er o+ ite$s sol +or each ty-e o+ -rouct"
The nu$#er o+ custo$ers o-ening accounts +or services"
The nu$#er o+ custo$ers closing accounts"
The total nu$#er o+ current custo$ers !ith service agree$ents"
'olu$e +igures, such as nu$#ers o+ -roucts -rouce, ra!
$aterials use, or hours o+ services #ille"
Inventory an stock lists !oul recor the nu$#er o+ ite$s on han +or each
ty-e o+ ite$ that !as hel"
In $ost cases these recors are co$-uterise, an -roucing re-orts is not
i++icult i+ the initial in+or$ation is entere as it occurs"
So$e s$all enter-rises o-erate !ith $anual -a-er recors in situations !ere
the nu$#er o+ transactions is not large"
Manu+acturing -rouction involves a $uch larger volu$e o+ in+or$ation,
such as scheules o+ -rouction runs, nu$#ers o+ ite$s -rouce, !ork in
-rogress, stock on han, hours o+ -rouction an so on""
+inancial Statements
A +ull set o+ +inancial state$ents inclues a #alance sheet, -ro+it . loss
state$ent, an -ossi#ly a cash +lo! state$ent"
,arge organisations generally -rouce a +ull set o+ +inancial state$ents on a
&uarterly or hal+<yearly #asis"
In s$aller enter-rises, a co$-lete set o+ +inancial state$ents $ay or $ay not
#e -rouce"
238
In $any cases, a cash<#ase accounting syste$ is use #ase on inco$e an
e3-enses, !ith ca-ital transactions such as e#t raising an asset -urchases
occurring as re&uire"
2inancial state$ents can #e use+ul in $anaging an evelo-ing a #usiness,
ho!ever a co$-lete set o+ auite accounts is generally only necessary +or
+or$al re-orting to e3ternal investors, an +or loge$ent to stock e3changes
or govern$ent regulators as re&uire"
!.#. ,nalysis
The analysis o+ #usiness results an conitions can #e #roken o!n into t!o
se-arate areas"
The o-erating conitions o+ the #usiness relate to the inco$e, e3-enses an
o-erations o+ the #usiness"
The +inancial structure relates to the !ay that the #usiness is +inance"
A -ro-erty invest$ent is an e3a$-le o+ this se-aration"
An invest$ent -ro-erty $ay generate inco$e, it $ay have $aintenance
e3-enses, an it $ay have a value that rises or +alls !ith changes in -ro-erty
values"
An investor !ho -urchase the -ro-erty $ay o so in $any i++erent !ays"
They $ay #uy the -ro-erty !ith cash, they $ay #orro! an use e#t to
-urchase the -ro-erty, or they $ay use a $i3ture o+ #oth"
The -ro-erty issues are ine-enent o+ the +inancing a--roach that !as use
to -urchase the -ro-erty"
In so$e res-ects, the #usiness itsel+ is an o-erating enter-rise, !hile the
+inancing structure is a +ra$e!ork an a shell that hols the #usiness in
-lace"
Revie!ing the +inancial state$ents is the #asis o+ revie!ing #oth the
o-erations an the +inancing structure o+ the #usiness"
Although the $anage$ent o+ a #usiness involves $ore etaile kno!lege
an control o+ the o-erations o+ the #usiness that the +igures that a--ear in the
231
+inancial state$ents, these +igures $ay still highlight $a9or issues an
structural -ro#le$s !ith the #usiness
3.5.1. 'ounts & finanial statements
Analysis o+ the #usiness o-erations an structure involves the +inancial
state$ents o+ the #usiness"
In the case o+ a large organisation, +inancial state$ents are -re-are on a
regular #asis"
In the case o+ s$aller enter-rises, +inancial state$ents can #e -re-are +ro$
the ra! +igures +or the #usiness o-eration, such as the total inco$e receive
uring the -erio, interest -ay$ents an so on"
3.5.1.1. 3er*s.are figures
In the case o+ co$-anies liste on stock e3changes, so$e +igures $ay #e
&uote as an a$ount -er share, rather than a total ollar +igure"
2or e3a$-le, a ivien -ay$ent is usually &uote as a nu$#er o+ cents -er
share, although the total a$ount is liste in the +inancial state$ents"
Total ollar +igures an -er<share +igures can #e converte #ack an +orth #y
$ulti-lying or iviing #y the nu$#er o+ shares"
In the case o+ a liste co$-any, this +igure is generally inclue !ith the
+inancial state$ents, or alternatively it can #e calculate using in+or$ation
such as the ivien<-er<share, an the total ivien a$ount +ro$ the cash
+lo! state$ent"
The +ollo!ing +or$ulas list so$e calculations that can #e use to eter$ine
earnings yiels an ivien yiels"
The earnings yiel is the return on the invest$ent at the current share -rice"
The ivien yiel re+lects the return that the ivien -ay$ent !oul
re-resent, co$-are to the current share -rice"
The ivien yiel is generally less than or e&ual to the earnings yiel, as the
ivien re-resents a -art o+ the earnings"
236
Dhen the +ull earnings are -ai as iviens, the ivien yiel an earnings
yiel !oul #e the sa$e"
The -art o+ the earnings that !as not -ai out as iviens $ay #e re+lecte
in an increase in the share -rice, all else #eing e&ual"
200
Per-share figures
share per dividends total
payments dividend total
shares of number
shares of number
amount total
share per amount
shares of number share per amount amount total
shares of number price share value l operationa
(arnings *ield
value l operationa
profit net
yield earnings
price share
share per earnings
yield earnings
ratio earnings price
yield earnings
1

yield earnings
ratio earnings price
1

Dividend *ield
price share
share per dividend
yield dividend
201
The o-erational value is generally ter$e the :$arket ca-italisation; in the
case o+ a liste co$-any"
3.5.1.2. Business :alue
So$e +inancial analysis involves calculations #ase on the value o+ the
#usiness"
In the case o+ a co$-any liste on a stock e3change, this can #e eter$ine
+ro$ the :$arket ca-italisation; o+ the co$-any"
This +igure is e&ual to the current share -rice, $ulti-lie #y the nu$#er o+
shares"
In the case o+ #usinesses that are not liste, a #usiness value can #e
eter$ine #y an ine-enent #usiness valuation"
2or the -ur-oses o+ revie!, an a--ro3i$ate value coul #e eter$ine +ro$
co$-arisons !ith sales an o++ers +or si$ilar #usinesses"
Businesses are o++ere +or sale in various -u#lications"
A rule o+ thu$# valuation coul also #e eter$ine #y a--lying a $ulti-le to
a +igure such as a $ulti-le o+ the current net -ro+it"
A #usiness !ith a reasona#ly sta#le inco$e $ay trae +or a value o+ aroun
ten ti$es net -ro+it, +or e3a$-le"
=o!ever, !hen this a--roach is use, ratios cannot #e eter$ine +ro$ the
#usiness value, as the #usiness value itsel+ has #een calculate #y a--lying a
+i3e $ulti-le"
3.5.1.3. #mall Enterprises
Analysis o+ s$all enter-rises $ay re&uire so$e changes to the +igures to
create a set o+ accounts that re+lects the o-eration as a -ure #usiness
enter-rise, se-arate +ro$ the -ersonal holings o+ the #usiness o!ners"
These +igures $ay not re-resent actual cash -ay$ents or cash holings,
ho!ever they !oul #e use to create a set o+ accounts that coul #e
analyse using the stanar a--roaches"
202
This coul inclue the +ollo!ing ste-sE
Allocating salaries +or the #usiness o!ners"
Re$oving -ersonal e3-enses +ro$ the e3-ense total"
Se-arating -ro-erty use +or #usiness -ur-oses +ro$ -ro-erty use
+or -ersonal -ur-oses"
Allocating rent or lease -ay$ents +ro$ the #usiness o!ners to the
#usiness !here assets !here use +or -ersonal -ur-oses"
As the #usiness o!ners o!n the sa$e -ro-erty !hether it is -art o+ the
#usiness or !hether it is hel -ersonally, this $akes no i++erence to the
#usiness o!nerCs total assets, ho!ever it ena#les an analysis to #e -er+or$e"
2or e3a$-le, so$e retail stores inclue a -ersonal resience attache to the
store itsel+"
In -re-aring #usiness accounts, the !hole -ro-erty !oul #e consiere to #e
o!ne #y the #usiness, !ith the #usiness o!ners receiving salaries, an
-aying rent to the #usiness +or the -rivate resience that !as -art o+ the
-ro-erty"
The rent a$ount coul #e eter$ine +ro$ the rent charge +or leasing
si$ilar #uilings to -rivate tenants"
Alternatively, the !hole -ro-erty coul #e consiere to #e o!ne
-ersonally, !ith the #usiness -aying rent to the #usiness o!ners +or
occu-ancy o+ the retail section o+ the -ro-erty"
The -ro+its o+ the #usiness also +lo! to the #usiness o!ners, so there is no
-ractical i++erence involve in !hether this is one #y salaries, or #y
iviens an -ro+it istri#utions"
These a--roaches $ay ena#le the +inances o+ the #usiness to #e revie!e
using the stanar calculations an a--roaches"
2or e3a$-le, these ste-s !oul have to #e taken #e+ore a value coul #e
esti$ate +or the #usiness using a $ulti-le, such as a $ulti-le o+ the current
-ro+it"
203
3.5.2. 3ro(ution anal$sis
3.5.2.1. 3ro(ution revie5
5rouction revie! an analysis involves revie!ing the nu$#er o+ ite$s
-rouce, the $i3 o+ i++erent -roucts -rocesse, an relate in+or$ation"
This involves revie!ing -hysical ite$s -rouce an services #ille, in
contrast to the +inancial analysis !hich revie!s cash +lo!s an -ro+ita#ility"
5rouction analysis is heavily use in $anu+acturing, ho!ever it coul also
#e a--lie to so$e service #usinesses"
5rouction $ay ty-ically #e revie!e an $anage #ase on $onthly
+igures"
In+or$ation that coul #e inclue in -rouction re-orts inclues ite$s such
as the +ollo!ingE
The nu$#er o+ ite$s -rouce +or each ty-e o+ -rouct"
The a$ount o+ ra! $aterials use, an the volu$e o+ su--lies such
as electricity an +uel that !ere use"
The nu$#er o+ hours o+ services #ille to clients"
The nu$#er o+ ne! custo$er accounts, or the nu$#er o+ sales"
The nu$#er o+ custo$ers closing accounts"
The -ercentage o+ ti$e that +acilities !ere availa#le +or -rouction"
The -ercentage o+ -lant ca-acity that !as use in -rouction"
Margins +or the -erio, incluing -rouction $argins o+ -rouct
sales to -rouct costs, an total $argins incluing allocation o+
+i3e costs across -rouction"
2igures can inclue the value +or the latest -erio, targets an #ugets,
+igures +or -revious -erios, co$-arisons !ith the sa$e -erio last year,
trens an -ercentage changes"
200

/o$-arisons !ith -revious -erios, such as the sa$e -erio last year, or a
series o+ $onthly results, can #e a use+ul #ench$ark an $ay highlight rising
or +alling trens"
=o!ever, s-eci+ic targets an #ugets $ay not al!ays #e #ene+icial"
S-eci+ic +igures $ay set a +ra$e!ork !hich alters the !ay that things are
one !ith the -ur-ose o+ reaching a target, rather than the -ur-ose o+
evelo-ing the #usiness #ase on +uture -ossi#ilities"
In so$e cases this can li$it the -ossi#ilities +or change an gro!th in the
o-erations o+ the #usiness"
3.5.2.2. 'vailabilit$
Availa#ility can #e a signi+icant issue in so$e -rouction -rocesses"
This re+ers to the -ercentage o+ ti$e that the +acilities !ere availa#le +or use"
This inclues ti$e !here the +acilities !ere not unavaila#le ue to scheule
$aintenance, -rouction -ro#le$s sto--ing -rouction, an lack o+ su--lies"
,o! availa#ility can #e ue to issues such as e&ui-$ent that is +aulty or !orn
out, -oor scheuling, lack o+ $aintenance, insu++icient inventory, or -oor
$anage$ent o+ inventory levels"
Also, in so$e -rocesses, the act o+ sto--ing an starting a -rouction -rocess
can #e highly e3-ensive, even !hen the length o+ ti$e itsel+ $ay #e &uite
short"
3.5.2.3. +apait$ utilisation
/a-acity utilisation re+ers to the volu$e o+ ite$s -rouce, co$-are to the
total volu$e that the +acility can -rouce"
2i3e costs such as the e-reciation o+ e&ui-$ent, $arketing costs,
a$inistration an so +orth are s-rea across the nu$#er o+ units that are
-rouce"
20*
The ca-acity utilisation +igure $ay have a large i$-act o+ -ro+ita#ility, ue to
the +act that a lo! volu$e o+ -rouction results in a higher +i3e cost #eing
#orne #y each ite$ that is -rouce"
Issues a++ecting ca-acity utilisation inclue custo$er e$an +or the
-roucts, availa#ility o+ +acilities, scheuling -rouction, an the -ro-ortion
o+ ti$e that the +acility is actually use"
3.5.2.4. /i)e( vs. variable osts
2i3e costs are costs that are the sa$e +or each -erio o+ ti$e, regarless o+
the nu$#er o+ ite$s -rouce"
Builing rents an e-reciation are e3a$-les o+ +i3e costs"
'aria#le costs relate to ra! $aterials, +uel, an other costs that are irect
in-uts to the -rouction o+ an iniviual ite$"
Salary costs can vary #et!een #eing +i3e costs to the #usiness an varia#le
costs o+ -rouction, e-ening on issues such as -er$anent, te$-orary an
contract e$-loyees, overti$e, a$inistration versus -rouction -ersonnel
an so +orth"
A si$ilar issue $ay arise in so$e service #usinesses"
2or e3a$-le, a +ir$ o+ accountants $ay have +i3e costs +or general
a$inistration, an varia#le costs +or salaries -ai to e$-loyees !ho -er+or$
#illa#le services +or clients"
In the case o+ a #usiness !ith a high -ro-ortion o+ +i3e costs, the volu$e o+
-rouction $ay have a larger i$-act on net -ro+it than a si$ilar #usiness in
!hich a high -ro-ortion o+ the costs are varia#le costs"
A high -ro-ortion o+ varia#le costs $ay reuce the risk to the #usiness o+
losses occurring uring -erios o+ slo! sales, !hile a high -ro-ortion o+
+i3e costs $ay result in strong cash +lo! !hen -rouction an sales
volu$es are high"
3.5.2.5. +ost strutures
20)
In so$e #usinesses the costs $ay #e ivie into a +e! $a9or ite$s, !hile in
other -rocesses a large nu$#er o+ ra! $aterials an in-uts $ay #e use"
A cost structure revie! can #e one to list all the iniviual costs that are
involve in -roucing a single ite$ o+ a -articular -rouct"
This coul #e use to consier alternative ra! $aterials, highlight $a9or
costs that coul #e aresse, an also highlight iniviual ite$s that coul
#e change or altere #y changing the $anu+acturing -rocesses"
3.5.2.!. 3ro(ut mi)
%ach -rouct $ay involve a i++erent set o+ ra! $aterials, a i++erent #alance
o+ +i3e an varia#le costs, an i++erent -ro+it $argins"
Although custo$er e$an is the $ain issue eter$ining -rouction, in
so$e cases the $i3 o+ -roucts coul #e altere to i$-rove the overall
e++iciency o+ the -lant -rouction"
2or e3a$-le, a large #atch o+ a -articular -rouct coul #e $ae an sol at
a iscount -rice, !ith the high volu$e o++setting the reuce $argin on the
iniviual sales"
3.5.3. Operating on(itions
A-erating conitions can #e revie!e #ase in +igures +ro$ the -ro+it<an<
loss state$ent"
The cash +lo! state$ent $ay also highlight relevant issues"
208
3.5.3.1. /inanial statements
2or the -ur-oses o+ this issue, a #asic -ro+it<an<loss state$ent $ay have the
+ollo!ing +or$
Revenue 10*
A-erating %3-enses )*
%BIT7A I earnings #e+ore interest, ta3, e-reciation 00
an a$ortisation
7e-reciation 1*
Total %3-enses 10
%BIT < %arnings #e+ore interest an ta3 2*
Interest 2
Ta3 8
4et 5ro+it 1)
In this state$ent, the +igures are calculate in the +ollo!ing !ay
Revenue Inco$e receive +ro$ sales
A-erating e3-enses %3-enses -ai uring the -erio
%BIT7A Revenue $inus o-erating e3-enses
7e-reciation The e-reciation accounting entry
Total %3-enses %BIT7A $inus e-reciation
%BIT Revenue $inus total e3-enses
Interest Interest -ai
201
Ta3 Ta3 -ai
4et 5ro+it %BIT $inus interest $inus ta3
The +igures have the +ollo!ing $eaning
Revenue The -ay$ents that the #usiness receive
+ro$ custo$ers"
A-erating e3-enses The -ay$ents $ae +or ra! $aterials, rent,
-ay$ents to e$-loyees etc"
%BIT7A This is the gross cash +lo! o+ the #usiness,
#e+ore -aying interest an ta3"
7e-reciation The ecline in the value o+ the assets ue to
the ecline in the value o+ e&ui-$ent an
other -hysical assets"
%BIT The earnings o+ the #usiness +ro$ gross
cash +lo!, $inus the value lost +ro$
e-reciation"
Interest Interest -ay$ents on e#t"
Ta3 Ta3 -ay$ents"
4et -ro+it The increase or ecrease in the value o+ the
assets ue to o-erations"
206
The #alance sheet +or this e3a$-le is liste #elo!
Assets
5ro-erty, -lant . e&ui-$ent 310
/ash 20
Total Assets 000
,ia#ilties
7e#t 1*0
4et Assets 2*0
Structural 'alue 8*
A-erational 'alue 32*
The last t!o ite$s, :structural value; an :o-erational value; are not -art o+
the stanar +inancial state$ents"
The :o-erational value; is the value o+ the #usiness, an can #e eter$ine
+ro$ the $arket ca-italisation o+ a liste co$-any, or an esti$ate o+ the sale
-rice +or other #usinesses"
The ter$ :#usiness value; $ay also #e use +or the o-erational value o+ the
#usiness"
The :structural value; is the i++erence #et!een the o-erational value an the
net assets +ro$ the #alance sheet"
This a$ount re+lects the aitional value o+ the #usiness, co$-are to the
-hysical assets, as an o-erating enter-rise"
In revie!ing the results, ratios or -ercentages are o+ten use, rather than
ollar a$ounts"
The ratios that !oul #e e3-ecte +or a #usiness vary greatly e-ening on
the inustry an the evelo-$ent stage +or the #usiness"
/o$-arisons $ay #e one against the ratios o+ si$ilar #usinesses in the sa$e
inustry, an against the average +igures +ro$ the inustry"
2*0
These +igures are availa#le in -u#lications issue #y stock e3changes an
govern$ent e-art$ents"
A--eni3 7 contains so$e #roa ranges +or a #asic range o+ #usiness
o-erations"
=o!ever, these +igures $ay vary greatly over ti$e an in s-eci+ic
circu$stances"
3.5.3.2. 1ross profit margin
The gross -ro+it $argin can #e calculate using the +ollo!ing +or$ula
revenue
EBITDA
in arg m profit gross
10*
3*

33 0.
33
In this case, the gross -ro+it $argin is 33L"
This inicates that 33L o+ the inco$e !as -asse on to the ne3t stage in the
accounts"
This +igure varies !iely #et!een i++erent inustries"
In so$e cases, the gross -ro+it $argin $ay #e as lo! as a +e! -ercent"
This occurs in situations that involve traing or istri#uting large volu$es o+
goos, !here cash in+lo!s an out+lo!s are high !ith a s$all i++erence
#et!een in-ut an out-ut -rices
In general #usiness o-erations, +igures o+ 20L or 30L !oul #e $ore
co$$on" (>> check)
2*1
This stage is the +irst issue involve in assessing o-erating -er+or$ance"
I+ the gross $argin is very lo!, then all other +igures #eco$e irrelevant"
The gross -ro+it is the a$ount that is -asse on to the ne3t stage o+ the
accounts, !hich is then allocate to e-reciation, interest, ta3, an net -ro+it"
I+ the gross -ro+it is s$all, a healthy net -ro+it +igure is not -ossi#le"
In these cases, the gross -ro+it can #e increase through raising revenue,
reucing e3-enses, or #oth"
This $ay -ro$-t a $ore etaile revie! o+ the entire #usiness irection"
=o!ever, revenue -ro#le$s $ay suggest that ne! -rouct evelo-$ent is
re&uire, -rices coul #e increase, $arketing e++orts coul #e i$-rove, or
that so$e $arkets shoul #e a#anone an other areas o+ #usiness e3-lore"
%3-ense -ro#le$s coul #e ue to e3cessive sta++ nu$#ers, a -oorly
organise or un-rouctive o-erating environ$ent, lack o+ attention to general
costs such as -ro-erty rents, or outate e&ui-$ent"
3.5.3.3. EB4T margin
The %BIT $argin can #e calculate using the +ollo!ing +or$ula
revenue
EBIT
in arg m EBIT
10*
2*

20
This inicates that, allo!ing +or all costs, the #usiness retaine 20L o+
revenue"
The range o+ ty-ical +igures +or this ratio varies !iely +ro$ inustry to
inustry"
2*2
A +igure that !as signi+icantly #elo! the inustry average $ay suggest that
serious changes !ere neee !ithin the #usiness o-eration"
A high +igure !oul generally suggest a #usiness that !as o-erating
e++iciently"
=igh $argins can also occur as a result o+ technology or other -ro-riety
assets that allo! the #usiness to eliver the -roucts or services at lo!er
costs than co$-etitors"
Alternatively, the #usiness $ay have a -rouct or service that is uni&ue an
$eets a high e$an +ro$ custo$ers"
3.5.3.4. ,eturn on assets
The return on assets +igure can #e calculate using the +ollo!ing +or$ulaE
assets
EBIT
assets on return
000
2*

.3 )
The return on assets +igure re-resents the return that the #usiness has
generate +ro$ the assets that are #eing use !ithin the #usiness"
The assets use #y a #usiness $ay vary !iely +ro$ one #usiness to another"
/ash +lo! #ase service #usinesses, an other #usinesses that lease $ost o+
their #uilings an e&ui-$ent, $ay have very +e! assets"
In these cases, the return on assets +igure $ay #e a very high nu$#er, an
$ay not #e a relevant +igure"
The return on assets +igure $ay #e relevant in the case o+ ca-ital<intensive
#usinesses such as $anu+acturing"
The return on assets +igure $ay also #eco$e relevant !hen it is lo!"
2*3
This inicates that assets are containe !ithin the #usiness that are #eing
-oorly utilise"
2or e3a$-le, in this situation the return on assets +igure is )"3 L"
In theory, i+ interest rates !ere aroun 8L +or e3a$-le, a higher return coul
#e achieve #y ceasing #usiness o-erations, selling the assets, an -lacing the
+uns in a #ank e-osit"
,o! return<on<assets +igures are co$$on !ithin $anu+acturing an ca-ital
intensive inustries"
Manu+acturing is a highly co$-etitive #usiness, an is a eclining section o+
the econo$y"
=o!ever, $any e++icient an !ell $anage $anu+acturing o-erations e3ist
an there is !ie sco-e +or success+ul o-eration in these +iel"
A lo! return on assets +igure $ay #e ue to a range o+ causes" These inclueE
1" ,o! ca-acity utilisation, !ith lo! -rouction ue to lack o+
custo$er e$an, e3cessive o!n<ti$e, or -oor scheuling"
2" Averca-acity, !here a -rouction +acility has #een #uilt that has
higher ca-acity than the unerlying e$an +or the -rouct"
This is a co$$on situation in large -ro-erty evelo-$ents" A
-ro9ect $ay #e care+ully -lanne an esigne, an then the esign
is e3tene as the -ro9ect -rogresses, !ith aitional stages an
e3tensions to the esign #eing ae"
The +inishe -ro9ect $ay #e $uch larger than the original esign"
This $ay result in large sections #eing unuse, an the -ro9ect
evelo-ers +inally selling the -ro9ect at a large loss, !ith the +inal
value #eing close to the value o+ the initial -ro9ect esign"
3" Autate an ine++icient e&ui-$ent or +acilities"
0" Hnuse assets" Assets are so$eti$es trans+erre through trusts an
inheritance, !here the original #usiness o-erator has lost interest in
the #usiness or has ie, an the assets re$ain in e3istence #ut are
not utilise"
2*0
This can also occur !hen sections o+ a #usiness o-eration are close
#ut the assets re$ain in the #usiness, such as vacant o++ice s-ace"
3.5.3.5. Tren(s in margins
The +ollo!ing +igures coul #e revie!e to highlight -ositive trens an
areas that $ay suggest evelo-ing -ro#le$s"
Tren changes in sales revenue"
Tren changes in e3-enses"
Tren changes in gross -ro+it $argin"
Tren changes in %BIT7A $argin"
Tren changes in %BIT $argin"
An u-!ar tren in revenue !oul generally #e an encouraging situation"
=o!ever, i+ e3-enses rose at a +aster rate than sales, $argins !oul shrink
an -ro+ita#ility !oul ecrease"
This situation can occur !hen a #usiness is e3-aning an sales are rising,
ho!ever e3-enses rise at a +aster rate than sales"
This leas to net -ro+it eclining, even though sales are rising"
This is a co$$on situation in high gro!th inustries !ith ne! co$-anies
ra-ily e3-aning"
/onversely, sales $ay #e +lat in a eclining inustry, ho!ever e3-enses $ay
+all steaily ue to i$-rove technology an $ore e++icient o-erations, an
-ro+ita#ility $ay actually increase"
Iniviual situations vary !iely, -articularly !hen -ersonal assets an
e3-enses are co$#ine !ith a #usiness o-eration, an these +igures nee to
#e inter-rete in the light o+ each -articular situation"
2**
3.5.3.!. Depreiation
The e-reciation +igure $ust #e inter-rete in light o+ the structure o+ the
asset #ase, an ratios using the e-reciation +igure are not usually calculate"
In a service #usiness or a #usiness that leases $ost o+ its e&ui-$ent, the
e-recation +igure $ay #e very lo! an $ay not #e relevant"
In cases !here there is a signi+icant a$ount o+ e&ui-$ent that is o!ne,
ho!ever, the e-reciation +igure $ay #e signi+icant"
A high e-reciation +igure !oul generally suggest a large &uantity o+ ne!
e&ui-$ent, !hich !oul generally #e a -ositive situation"
=o!ever, ue to the heavy e-reciation costs, the e&ui-$ent !oul have to
#e +ully utilise to o++set the costs an -rouce a net -ro+it"
The return<on<assets +igure coul #e relevant in this case"
A lo! e-reciation +igure in a $anu+acturing #usiness that o!ns its
e&ui-$ent $ay inicate that the e&ui-$ent is ol an out<o+<ate"
This $ay #oost the accounting -ro+it, as the e-reciation +igure !oul #e
lo!"
=o!ever, this is also likely to lea to less e++icient -rouction, an $ay
result in higher -rouction costs"
3.5.3.7. +apital E)pen(iture
/a-ital e3-eniture is the +uns that !ere s-ent on -urchasing ne!
e&ui-$ent uring the -erio"
In a s$all enter-rise, this ite$ $ay vary greatly +ro$ one -erio to another,
as $a9or -urchases o+ e&ui-$ent only occur occasionally"
In a large #usiness enter-rise !ith a !ie range o+ se-arate o-erations, the
total ca-ital e3-eniture $ay not change signi+icantly ue to iniviual
transactions"
2*)
/o$-aring the ca-ital e3-eniture +igure !ith the e-reciation +igure can #e
use to ienti+y the a--roach to +uture changes that is currently #eing use #y
the #usiness"
Ane a--roach to this issue coul #e to calculate a :ca-ital e3-ansion ratio;"
A +igure o+ one !oul inicate that the current #ase o+ -hysical assets !as
#eing $aintaine at a steay level, a +igure a#ove one !oul inicate an
e3-ansion in the #ase o+ -hysical assets, !hile a +igure #elo! one !oul
inicate a eclining #ase o+ e&ui-$ent an +acilities"
The coul #e calculate using the +ollo!ing +or$ula
on depreciati
enditure exp capital
ratio ansion exp capital
I+ the ca-ital e3-eniture is signi+icantly lo!er than the e-reciation +igure
+or a nu$#er o+ years, this inicate that the #usiness $ay #e o-erating !ith a
eclining outlook"
This situation $ay involve the ca-ital stock #eing run o!n"
Sales, cash +lo! an -ro+its coul all #e strong, ho!ever this $ay have
re-resente an unsustaina#le long<ter$ situation, as the -ro-erty, -lant an
e&ui-$ent !as #eing run o!n #ut !as not #eing re-lace"
This $ay #e eli#erate in so$e cases, ue to an e3cess o+ ca-ital stock or an
inention to e3it the #usiness o-erations at a +uture ti$e"
=o!ever, in general this $ay inicate that ae&uate invest$ent in ne!
e&ui-$ent !as not #eing $ae"
A #usiness o-erating uner these conitions $ay have several strong years
an the suenly evelo- serious -ro#le$s"
/a-ital e3-eniture that is si$ilar in si@e to e-reciation over a nu$#er o+
years inicates a sta#le ongoing o-eration"
A ca-ital e3-eniture +igure that is signi+icantly a#ove the e-reciation +igure
+or a nu$#er o+ years inicates an e3-ansion -hase"
2*8
Businesses o+ten have a $a9or ca-ital e3-eniture -rogra$ +or a -erio o+
ti$e, #e+ore returning to sta#le o-erations"
2or e3a$-le, a cine$a o-erator $ay i$-le$ent a $a9or -rogra$ o+
re+ur#ishing cine$as an #uiling ne! +acilities over an eighteen $onth
-erio, #e+ore returning to sta#le o-erations +or the +ollo!ing years"
In cases !here a $a9or ca-ital e3-eniture -rogra$ is i$-le$ente, this $ay
#e a -ositive sign +or the +uture o+ the #usiness"
=o!ever, the iniviual entries !ithin the accounts nee to #e inter-rete
care+ully uring this ti$e, as large variations in +igures can occur as $a9or
changes in the ca-ital structure o+ the #usiness are $ae"
3.5.4. /inanial struture
3.5.4.1. #truture
The %BIT $argin e3a$ines ho! e++iciently a #usiness $anages costs, !hile
the return on assets $easure ho! e++iciently the #usiness utilise its assets"
=o!ever, these assets $ust #e +une, an the +inancial structure analysis
e3a$ines the !ay in !hich the assets are +une"
2uning through e#t an e&uity can #e consiere a se-arate issue +ro$ the
assets an o-eration o+ the #usiness"
The return on assets +igure s-eci+ies the return +ro$ the #usiness o-erations,
#ase on the assets that are use in the #usiness activity"
This a--roach is -articularly relevant to ca-ital<intensive #usinesses such as
$anu+acturing, an is less relevant to cash +lo! #ase activities such as
service #usinesses"
3.5.4.1.1. 1earing
The assets o+ a #usiness can #e +une using a co$#ination o+ e#t an
e&uity"
7e#t involves #orro!e +uns an #ears in ongoing interest cost
2*1
%&uity is the e3cess +uns !ithin the #usiness an is the net value o+ the
#usiness assets"
The gearing ratio is a $easure o+ the -ro-ortion o+ e#t an e&uity that are
use to +un the assets"
The ratio o+ e#t to e&uity is so$eti$es use, ho!ever an alternative
$easure is the ratio o+ e#t to total assets"
This gives the -ercentage o+ the assets that have #een +une !ith e#t"
This gearing ratio can #e calculate using the +ollo!ing +or$ula
assets
debt
gearing
000
1*0

31
This inicates that 31L o+ the assets have #een +une !ith e#t, an the
re$aining )2L !ith e&uity"
(earing $agni+ies the returns o+ the #usiness, +or #oth a -ositive return an a
negative return"
7e#t also carries a +i3e regular interest cost, an this can cause cash +lo!
-ro#le$s an eventually li&uiation i+ the e#t levels are too high"
=igh e#t levels are use !hen the inco$e an e3-enses are sta#le an
-reicta#le"
This inclues situations such as -ro-erty invest$ent an in+rastructure
invest$ent such as toll roas"
,o! e#t levels are use !hen inco$e is highly volatile or unsta#le"
%3a$-les o+ this $ay inclue seasonal inustries, co$-anies in the early
stages o+ evelo-$ent an co$-anies that o-erate on a -ro9ect evelo-$ent
#asis such as #iotechnology co$-anies"
2*6
(earing levels in general #usiness o-erations are co$$only in the 20L to
*0L range"
(earing levels signi+icantly a#ove *0L $ay inicate a risk o+ -ro#le$s
evelo-ing ue to e3cessive e#t"
In other circu$stances, a lo! gearing ratio $ay inicate the e3cessive e&uity
ca-ital is tie u- !ithin the #usiness, an the #usiness !oul #e #etter
structure #y reucing the e&uity ca-ital an increasing e#t levels"
3.5.4.1.2. 4nterest over
Interest cover is a ratio that is use to $easure the risk o+ the #usiness +acing
+inancial istress i+ o-erating conitions eteriorate"
This can #e calculate using the +ollo!ing +or$ula
erest int
EBIT
er cov Interest
2
2*

* 12.
An interest cover +igure over +ive !oul generally inicate that the #usiness
!as not at serious risk o+ +inancial -ro#le$s ue to e#t -ay$ents i+
conitions eteriorate"
Interest cover +igures o+ signi+icantly less than +ive $ay inicate that
-ro#le$s coul evelo- i+ conitions eteriorate"
Although the gearing ratio is o+ten use in this conte3t, +inancial survival in
the short an $eiu$ ter$ is a cash +lo! issue, not an asset issue"
The interest cover ratio is the $easure that #est highlights the #u++er that
e3ists !ithin the current cash +lo! to cover the +i3e cost o+ servicing the
e#t"
2)0
3.5.4.2. 3rofitabilit$
3.5.4.2.1. ,eturn on e9uit$
The :return on e&uity; ratio $easures the net -ro+it o+ the #usiness co$-are
to the shareholerCs e&uity"
This +igure can co$-are to alternative invest$ent returns that $ay #e
availa#le i+ the assets !ere sol, the e#ts !ere re-ai, an the e&uity +uns
!ere investe in an alternative invest$ent"
The return on e&uity +igure can #e calculate using the +ollo!ing +or$ula
e!uity
profit net
e!uity on return
2*0
1)

.0 )
The RA% is a #usiness<#ase ratio rather than a $arket<#ase ratio"
The RA% only e-ens on the +inancial results, an is not a++ecte #y the
value o+ $arket -rice o+ a #usiness"
In contrast, the earnings yiel is #ase value o+ the #usiness"
The return on e&uity s-eci+ies the return on the ca-ital +uns that are hel
!ithin the #usiness, !hile the earnings yiel s-eci+ies net -ro+it as a
-ercentage return o+ the #usiness value"
3.5.4.2.2. Earnings $iel(
%arnings yiel is a $arket ratio, an is e-enant on the $arket value o+ the
#usiness"
2)1
This is the return that !oul #e achieve +ro$ -urchasing the #usiness at its
current value"
The earnings yiel is calculate using the +ollo!ing +or$ula
value l operationa
profit net
yield earnings
32*
1)

.6 0
In the case o+ co$-anies liste on a stock e3change, this +igure is usually
&uote in the +or$ o+ a :-rice earnings ratio;, !hich is the inverse o+ the
earnings yiel"
profit net
value l operationa
ratio earnings price
share per earnings
price share
ratio earnings price
yield earnings
ratio earnings price
1

An also, the earnings yiel $ay #e calculate +ro$ the -rice<earnings ratio
using the +ollo!ing +or$ula"
ratio earnings price
yield earnings
1

2or e3a$-le, a co$-any $ay have earnings -er share o+ 1*c, an a current
share -rice o+ G1"2*"
2)2
In this case, the -rice<earnings ratio $ay #e calculate using the +ollo!ing
e3a$-le"
1*
12*
ratio earnings price
3 1.
The earnings yiel $ay then #e calculate using the +ollo!ing e3a$-le
3 1
1
.
yield earnings
12
Base on this +igure, at the current share -rice an net -ro+it level, the
invest$ent return +ro$ iviens an ca-ital gro!th involve in -urchasing
the shares $ay #e 12L"
The actual change in the share -rice $ay re+lect changes in the co$-anyCs
net -ro+it an gro!th outlook, changes in econo$ic conitions, an changes
in investorCs interest in the co$-any or in the stock $arket in general"
3.5.4.2.3. ,OE vs. Earnings ;iel(
In cases !here the $arket value is the sa$e as net asset value, the earnings
yiel an RA% !ill #e the sa$e +igure"
/hanges to the #usiness $ay a++ect the return on e&uity, ho!ever they $ay
not a++ect the earnings yiel greatly"
This is #ecause a change in the #usiness o-erations !ill #e re+lecte in a
change in the #usiness value, !ith the earnings yiel re$aining +airly
constant"
In the case o+ a #usiness #eing -urchase, the earnings yiel eter$ines the
return to the investor, rather than the return on e&uity"
2)3
Although the RA% $ay #e relevant in assessing the structure an general
e++iciency o+ a #usiness, it oes not corres-on to the invest$ent return +ro$
-urchasing a #usiness in cases !here the -urchase -rice is i++erent +ro$ the
net asset +igure"
3.5.4.2.4. ,eturns on assets an( e9uit$
The RAA an RA% +igures #eco$e relevant !hen they are lo! values, as
this inicates that ca-ital is tie u- !ithin the #usiness, an is not #eing use"
In these situations, increases in volu$es through $arketing activities an
-rouct evelo-$ents, reinvesting ca-ital in ne! +acilities, an istri#uting
e3cess e&uity ca-ital to shareholers $ay #e use to increase the returns +ro$
the investe ca-ital"
The return on assets +igure is #ase on the o-erations that are conucte
using the assets, !hile the return on e&uity +igure is #ase on the o-erational
result, an the +uning $i3 o+ e#t an e&uity that is use"
In the case o+ asset<#ase #usinesses such as $anu+acturing, the assets +or$
the #asis o+ the #usiness o-eration"
The relationshi- #et!een the o-erational return on assets, an the -re<ta3
return on e&uity +uns, can #e su$$arise in the +ollo!ing +or$ula"
( ) rate erest int debt "#A
g
g
"#A "#E

+
1
In this +or$ula, the varia#les have the +ollo!ing $eanings
RAA Return on assets
RA% Return on e&uity
g (earing ratio
In the case o+ no e#t an e&uity<+une assets, the return on e&uity is e&ual
to the return on assets"
2)0
At a gearing level o+ *0L, as an e3a$-le, the +ollo!ing +or$ula !oul
a--ly"
( ) rate erest int debt "#A "#A "#E +
This illustrates that the e++ect o+ gearing e-ens on !hether the return on
assets is higher than the interest rate on the e#t, or lo!er"
2or a return on assets that is higher than the e#t interest rate, +uns are
a++ectively #eing #orro!e an investe at a higher rate o+ return, an the
return on e&uity !oul increase"
Dhen the return on assets is lo!er than the e#t interest rate, +uns are
e++ectively #eing #orro!e an investe at a lo!er rate o+ return, an the
return on e&uity !oul ecrease"
This e++ect is illustrate in the +ollo!ing gra-h, !hich sho!s the e++ect o+
gearing on the return on e&uity +or a range o+ i++erent return on asset +igures"
*eturn on E4uity
Debt interest rate of 8<
*2"<
*1"<
"<
1"<
2"<
3"<
4"<
5"<
!"<
7"<
8"<
9"<
1""<
11"<
12"<
"< 2"< 4"< !"< 8"< 1""<
$earing *atio
*
e
t
u
r
n

o
n

E
4
u
i
t
y
,O' 4<
,O' !<
,O' 8<
,O' 1"<
,O' 12<
,O' 14<
,O' 1!<
2igure 1
2)*
3.5.4.3. 4mproving returns
The returns on assets an e&uity are #ase on three +una$ental values"
These are the +ollo!ing three ite$s"
%++iciency The cost o+ +acilities, an the costs o+ -rouction
or services, in co$-arison to the goos or
services -rouce"
'olu$e Sales levels in co$-arison to the ca-acity o+ the
+acilities or the organisation, an in co$-arison
to the level o+ ca-ital investe"
/a-ital The e&uity an assets investe in the enter-rise"
3.5.4.3.1. Effiien$
%++iciency involves the a$ount o+ resources that are neee to -rouce a
certain volu$e or a -rouct or service"
Increase e++iciency allo!s a -articular volu$e to #e elivere using less
resources"
%++iciency $ay #e i$-rove through investing in ne! +acilities an
e&ui-$ent an through i$-le$enting $ore e++ective -roceures an
-rocesses"
3.5.4.3.2. :olumes
The volu$e o+ goos sol a++ects the inco$e o+ the #usiness, an -ossi#ly
also the e++iciency o+ the o-eration"
/osts -er unit $ay #e lo!er at high -rouction volu$es than at lo! volu$es,
ue to the a#ility to s-rea the +i3e costs o+ the #usiness across a large
nu$#er o+ ite$s"
2))
'olu$es $ay #e increase through evelo-ing ne! -roucts, through
increasing e++iciency to allo! -rices to #e lo!ere, an through increases
$arketing activities"
3.5.4.3.3. :olume & Effiien$ lin6s
'olu$e an e++iciency are not ine-enent e++ects"
An increase in e++iciency $ay lea to an increase in sales, through the a#ility
to o++er lo!er -rices"
Also, an increase in sales $ay lea to an increase in e++iciency, !hich $ay
occur !hen a greater -ercentage o+ -rouction ca-acity is actually use
!ithin a -erio o+ ti$e"
This link $ay create #oth -ositive an negative cycles"
In the case o+ increasing sales or e++iciency, this $ay +ee into an increase in
the other value, an a re-eating cycle o+ e3-ansion $ay occur"
/onversely, a +all in e++iciency or sales coul lea to a +all in the other value,
!hich coul lea to a negative s-iral o+ +alling sales an e++iciency levels"
This a++ect illustrates the i$-ortance o+ e++ective o-eration an evelo-$ent
o+ the #usiness +or the long ter$ survival an gro!th o+ the #usiness"
3.5.4.3.4. E)ess apital
Reucing the e&uity ca-ital !ithin a #usiness, !hile $aintain e3isting
o-erations, $ay increase the -ercentage returns on the e&uity +uns that are
hel !ithin the #usiness"
Dhile this -rocess $ay not a++ect the ollar return +ro$ the #usiness, it $ay
allo! the e3cess e&uity ca-ital to #e investe else!here"
The return +ro$ the #usiness is eter$ine #y the net -ro+it an the $ini$u$
level o+ e&uity that is neee to su--ort the #usiness o-eration"
Any aitional e&uity +uns e++ectively earn a @ero return, !ith the total
return across all e&uity ca-ital re+lecting the average o+ the return on the
necessary +uns, an the @ero return on the e3cess +uns"
2)8
Dhere e&uity +uns have accu$ulate !ithin a #usiness +ollo!ing a -erio
o+ success+ul o-eration or the sale o+ a $a9or asset, a ca-ital istri#ution to
the #usiness o!ners $ay #e conucte, to reuce the e&uity #ase to the level
that is re&uire to su--ort the #usiness o-erations"
A si$ilar issue $ay arise in the case o+ asset values"
In situations !here the e3isting #usiness activities coul #e -er+or$e using
+e!er assets, then the returns on assets an e&uity $ay #e i$-rove"
3.5.4.3.5. +alulate( figures vs. atual returns
/are shoul generally #e taken in co$-aring return +igures #et!een i++erent
#usinesses, an through -erios o+ ti$e"
2or e3a$-le, one -ossi#le #usiness structure $ay involve o!ning +acilities"
These +acilities !oul #e re+lecte as assets on the #alance sheet"
An alternative a--roach $ay involve leasing e&ui-$ent or hiring +acilities"
In this secon a--roach, the value o+ the assets o+ the #usiness $ay #e $uch
lo!er than in the case o+ the +irst #usiness"
=o!ever, the o-erations o+ the #usiness $ay #e ientical, an the net -ro+it
$ay #e the sa$e in each case"
In this situation, the return on assets +igure in the secon case $ay #e $uch
higher than in the +irst structure, even through the value that is create
through the #usiness activity is e++ectively the sa$e in each case"
Also, in the case o+ service #usinesses that o-erate on a cash +lo! #asis, the
value o+ #oth the assets an the e&uity +igures $ay #e very lo!"
This $ay lea to high -ercentage +igures +or the returns on assets an e&uity"
=o!ever, these -ercentage returns !oul re+lect the s$all value o+ the
ca-ital, rather than the large value o+ the -ro+it"
In circu$stances such as these, the earnings yiel $ay #e a $ore suita#le
$easure o+ the returns +ro$ the #usiness, #ase on the #usinessCs current
value"
2)1
3.5.4.4. +apital returns issues
3.5.4.4.1. 4nput :s. Output figures
The value o+ a #usiness is eter$ine #y the net -ro+it, not the other !ay
aroun"
2)6
In eter$ining a rate o+ return, the +ollo!ing se&uence $ay #e +ollo!e
Step aria"le -*pe Process
1 Business value Ine-enent 7eter$ine the #usiness
value +ro$ a share -rice
or valuation"
2 4et -ro+it Ine-enent 7eter$ine the net -ro+it"
3 %arnings yiel 7e-enant /alculate the rate o+
return"
This a--roach $ay #e relevant in calculating a rate o+ return #ase on a
current #uying or selling -rice"
=o!ever, these ste-s o not re+lect the +una$ental nature o+ the interaction
that occurs #et!een net -ro+it, rates o+ return, an the #usiness value"
%++ectively, the +ollo!ing se&uence eter$ines the relationshi- #et!een the
three values
Step aria"le -*pe (ffect
1 4et -ro+it Ine-enent The net -ro+it is
eter$ine #y the
#usiness activity"
2 %arnings yiel Ine-enent A rate o+ return a--lies
#ase on the ty-e o+
#usiness an the gro!th
outlook"
3 Business value 7e-enant The #usiness value is
eter$ine #y the net
-ro+it an the rate o+
return"
280
3.5.5. T.e ost of e9uit$
Interest -ay$ents $ust generally #e $ae on e#t"
The i++erence #et!een the inco$e +ro$ o-erations an the -ay$ents +or
interest eter$ines the net -ro+it or loss that is achieve #y #orro!ing +uns
an investing the ca-ital in #usiness activities"
A si$ilar e3-ense oes not occur !ith e&uity"
In the +ollo!ing e3a$-le, a #usiness has G100 o+ assets, !hich are entirely
+une !ith e&uity"
The net -ro+it +ro$ o-erations, allo!ing +or inco$e an e3-enses, incluing
e-reciation, is G3 in this e3a$-le"
The +igures are -resente in the +ollo!ing list"
Assets (%&ui-$ent) 100
7e#t 20
%&uity 10
Inco$e 20
%3-enses 18
4et 5ro+it 3
Return on %&uity 3"1 L
3.5.5.1. Opportunit$ ost
This $ay a--ear to #e a -ro+ita#le enter-rise"
=o!ever, the #usiness inclues net assets !ith a value o+ G10"
281
The assets coul #e sol, an the +uns coul -otentially #e investe
else!here"
2or e3a$-le, the interest rate on #ank e-osits $ay #e *L at the ti$e o+ the
analysis"
I+ the assets !ere sol an the ca-ital !as -lace on e-osit, the return that
!oul #e earne !oul #e G0 -er year"
By retaining the +uns in the +or$ o+ the e3isting assets, the #usiness is
loosing the o--ortunity to receive the G0 that !oul #e receive i+ the assets
!ere sol an the $oney !as e-osite"
This is kno!n as :o--ortunity cost;"
Although a cash +lo! is not irectly involve, the G10 o+ e&uity e++ectively
has a cost o+ G0 -er year, as this is the a$ount that is #eing lost #y not
investing the ca-ital else!here"
This a$ount is also kno!n as the :cost o+ e&uity;"
This is the sa$e conce-t as the cost o+ interest -ay$ents on e#t, although in
the case o+ e&uity, cash transactions o not occur"
3.5.5.2. E)ess returns
A $ore accurate analysis o+ the structure an -ro+ita#ility o+ a #usiness $ay
#e achieve #y incluing the cost o+ e&uity as an e3-ense, in a si$ilar !ay to
the interest cost o+ e#t"
This coul #e calculate using the +ollo!ing +or$ula
rate return e!uity e!uity e!uity of t cos dollar
The return on e&uity, a+ter a9usting +or the cost o+ e&uity, coul #e ter$e
the :e3cess return on e&uity;"
This +igure $ay #e -ositive or negative, an $ay inicate the i++erence
#et!een the return on e&uity o+ the #usiness o-eration, an the returns
availa#le +ro$ alternative co$-ara#le invest$ents"
282
All return +igures $ay #e negative in the case o+ loss<$aking o-erations,
ho!ever the stanar returns on e&uity an assets !oul #e -ositive in the
case o+ -ro+ita#le #usiness o-erations"
This +igure !oul #e relative to alternative invest$ents, rather than an
a#solute return +igure"
Aing this cost o+ e&uity as an e3-ense, the e3cess return on e&uity coul
then #e calculate using the +ollo!ing +or$ula"
e!uity
rate return e!uity e!uity profit net
e!uity on return excess

Assu$ing a cost o+ e&uity rate o+ *L, the +igures +ro$ the -revious e3a$-le
coul #e re<state in the +ollo!ing !ay"
Assets (%&ui-$ent) 100
7e#t 20
%&uity 10
Inco$e 20
%3-enses
(eneral e3-enses 18
/ost o+ e&uity *
Total %3-ense 22
4et 5ro+it (a9uste) < 2
%3cess Return on %&uity < 2"* L
This analysis inicates that the #usiness is achieving a negative return, in
co$-arison the alternative invest$ents that are availa#le"
283
3.5.5.3. 'sset base returns
Incluing a cost o+ e&uity $ay also ena#le the e3cess return on the asset #ase
to #e calculate, a+ter allo!ing +or +uning costs"
This coul #e ter$e an :e3cess return on assets;"
A -ositive +igure $ay inicate that the return +ro$ the asset #ase !as larger
than the return that !oul #e availa#le +ro$ investing the e#t an e&uity
+uns in alternative invest$ents"
A stanar return on assets +igure eter$ines the return on the asset #ase,
#e+ore +uning costs"
2oe e3a$-le, the +ollo!ing +or$ula coul #e use to calculate the e3cess
return on the asset #ase, allo!ing +or +uning costs incluing the cost o+
e&uity"
assets
rate return e!uity e!uity profit net
assets on return excess

280
2or +ollo!ing e3a$-le -resents a set o+ +igures +or the e3cess return on
assets, a+ter +uning costs"
Assets (%&ui-$ent) 100
7e#t 30
%&uity 80
Inco$e 20
%3-enses
(eneral e3-enses 18
Interest 1"*
Total %3-enses 11"*
/ost o+ e&uity 3"*
4et 5ro+it (incl" cost o+ e&uity) <2
%3cess Return on assets <2 L
3.5.5.4. T.e ost of e9uit$ rate
'arious a--roaches coul #e taken to eter$ining the rate to a--ly to the
cost o+ e&uity"
Ane a--roach $ay involve using the sa$e rate as the e#t interest rate"
This $etho has an avantage in that it is si$-le to i$-le$ent, an in that it
re$oves any variation in the ca-ital return +igures that !oul #e cause #y
changing the -ro-ortions o+ e#t an e&uity"
An argu$ent +or this a--roach $ay #e that the e#t interest rate $ay
a--ro3i$ately re+lect the general level o+ interest rates in the econo$y, an
that this $ay re-resent the o--ortunity cost that is lost #e holing the ca-ital
in the +or$ o+ -hysical assets"
28*
Another a--roach $ay #e to select a rate #ase on alternative invest$ents
that !ere currently availa#le"
This coul inclue other #usinesses o+ a si$ilar escri-tion, or alternatives
such as cash e-osits or a rate #ase on #roa invest$ent returns"
2or$al analysis o+ the cost o+ ca-ital is generally #ase on a +inancial $oel
kno!n as the :ca-ital asset -ricing $oel;"
This $oel is iscusse in the section #eginning on -age 8))"
The $oel esti$ates a cost o+ e&uity +ro$ a -ara$eter that is relate to the
volatility o+ the #usiness value, an the relationshi- #et!een this volatility
an the returns on other invest$ents"
A si$-ler a--roach that incor-orates the volatility issue $ay involve
selecting a #ase interest rate, an aing a risk -re$iu$ to re+lect the
volatility o+ the #usiness inco$e an the #usiness value"
This is #ase on the a++ect that there is so$eti$es a link #et!een the
volatility o+ an invest$ent return, an the average invest$ent return itsel+"
The risk -re$iu$ is chosen to re+lect the volatility o+ inco$e an asset
values, !ith high risk -re$iu$s #eing ae +or highly volatile inco$es"
The issue o+ risk -re$iu$s is iscusse in $ore etail in the section
#eginning on -age 8)2"
2or e3a$-le, a risk -re$iu$ o+ *L $ay #e ae +or a $eiu$<risk
#usiness"
Assu$ing that #ase rates +or lening an e-osits !ere aroun 1L, the cost
o+ e&uity coul #e calculate using the +ollo!ing e3a$-le
premium ris$ rate base e!uity of t cos +
* 1 +
13
28)
$isk-ad2usted returns
A #ene+it o+ using a risk -re$iu$ a--roach in the e3cess return on ca-ital
calculations is that this a--roach inclues an a9ust$ent #ase on the
volatility o+ the inco$e an the #usiness value"
All else #eing e&ual, a sta#le inco$e strea$ $ay generally #e -re+era#le to a
volatile inco$e strea$"
Sta#le inco$e $ay allo! easier -lanning, $ay reuce the ca-ital re&uire to
act as a #u++er against changes in cash +lo!, an $ay -rovie aitional
o-tions to the #usiness, such as #eing a#le to sustain high e#t levels !ithout
e3cessive risk"
The values -lace on #uying an selling #usinesses an other invest$ents are
generally irectly relate to the volatility o+ the inco$e an asset values"
3.5.!. #tan(ar(ising 'nal$sis
A nu$#er o+ issues can a++ect the analysis o+ a set o+ #usiness results"
These inclue $i3ing -ersonal e3-enses !ith #usiness e3-enses, +uning
arrange$ents such as leasing, an so on"
The +ollo!ing a--roach s-eci+ies one alternative +or -re-aring a set o+
accounts +or analysis that coul #e co$-are !ith other #usiness an !ith
inustry averages"
This a--roach !oul also -rouce a set o+ +igures that !oul recor the -ure
#usiness o-eration, an coul #e use to esti$ate a value +or the #usiness, or
to co$-are ratios !ith alternative invest$ents"
These changes $ay involve the +ollo!ing ste-sE
1" 5re-are a stanar #alance sheet an -ro+it . loss state$ent"
2" %3clue any assets use +or -ersonal -ur-oses only, an e3clue any
-ersonal e3-enses"
3" A salaries +or the #usiness o!ners, at the e&uivalent level that
!oul #e re&uire to hire sta++ to o-erate the #usiness so that it
288
coul #e sol as an o-erational #usiness, ine-enent o+ the
#usiness o!ners"
0" Re$ove any -ro-erty relating to general o++ice or retail s-ace" Also
re$ove an e&uivalent a$ount o+ e#t, i+ -resent" Reuce the interest
-ai, or increase interest earne, #y an a$ount e&ual to the -ro-erty
value $ulti-lie #y the e#t interest rate"
*" A a rent e3-ense +or the e&uivalent general retail or o++ice s-ace"
)" Retain any s-ecialise +acilities such as $anu+acturing +acilities"
8" In the case o+ lease assets, a an asset an a e#t to the #alance
sheet" A an interest e3-ense at the current e#t interest rate, an
a a e-reciation e3-ense that is e&ual to the i++erence #et!een
the interest -ay$ent an the lease -ay$ent"
1" Dhen calculating e3cess ca-ital returns, a a :cost o+ e&uity;
e3-ense, e&ual to the value o+ the e&uity $ulti-lie #y the interest
rate on the e#t"
These ste-s !oul translate a variety o+ +uning structures into a stanarise
structure that use #alance<sheet assets +or e&ui-$ent an s-ecialise
+acilities, an rent -ay$ents +or general retail an o++ice s-ace"
The level o+ e#t $ay still vary +ro$ one case to another, although e#t !ith
an e&uivalent value to any general -ro-erty holings coul #e re$ove"
The +ollo!ing e3a$-le -resents a sa$-le set o+ +igures"
A stanarise a9uste set o+ +igures is also sho!n, together !ith ratios
calculate +ro$ the a9uste +igures"
281
,nitial Accounts
Assets
Resiential Builing 00
Retail S-ace )0
/ash 30
Total Assets 130
,ia#ilities
7e#t 100
4et Assets 30
Sales 2*
A-erating %3-enses 10
5ersonal %3-enses 0
,ease 5ay$ents 0
4et 5ro+it 8
286
Ad2usted Accounts
Assets
%&ui-$ent 20
/ash 30
Total Assets *0
,ia#ilities
7e#t 20
4et Assets 30
Sales 2*
(eneral %3-enses 10
Salaries 3
Rent 2
7e-reciation 2
Interest 2
4et 5ro+it )
/ost o+ %&uity 0
4et 5ro+it a+ter e&uity cost 2
(earing 00 L
Interest /over 0
Return on Assets 12 L
Return on %&uity 20 L
%3cess return on e&uity )"8 L
%3cess return on assets 0 L
210
3.5.7. 4nterpreting anal$sis results
Re-orts, calculations an analysis can -rovie valua#le unerstaning an
in+or$ation a#out the #usiness o-eration"
A #usiness cannot #e $anage e++ectively unless the key +inancial an
o-erating results are calculate an revie!e"
3.5.7.1. Deision ma6ing vs. me.anial targets
Margins an ratios $ay #e use as in-uts to the ecision $aking -rocess,
rather than #eing a--lie $echanically as targets, #ench$arks an so on"
This is illustrate #y the +act that t!o alternative structures $ay -rouce
!iely i++erent ratios, even though the e++ective value o+ the #usiness
enter-rise $ay #e the sa$e in each case"
Margin an ratio analysis $ay highlight issues an -ro#le$s that nee to #e
aresse"
At each stage in the o-eration or evelo-$ent o+ a #usiness, i++erent issues
$ay arise, an current e++orts $ay nee to #e +ocuse on a range o+ i++erent
-ro#le$s"
Revie!ing an analysing the results $ay highlight the +uture irections
availa#le to the #usiness, an the activities that shoul #e unertaken to $ove
the #usiness +or!ar"
A se-arate issue a--lies !ith service level agree$ents, !here stanars such
as $ini$u$ availa#ility levels are set in avance, an action $ay #e neee
i+ the service that is -rovie +alls #elo! the agree stanar"
2or e3a$-le, a co$-uter su--ort service agree$ent $ay #e #ase on an
availa#ility level o+ 66"*L u-<ti$e"
Dhile rano$ events al!ays occur, i++erent issues arise i+ the service that is
su--lie is +una$entally i++erent +ro$ the service stanar that !as
initially set"
Re&uire$ents such as availa#ility levels, res-onse ti$es to -ro#le$s an so
+orth are co$$only s-eci+ie !hen teners are invite +or service su--ly
contracts"
211
3.5.7.2. Business & 4nvestment anal$sis
The +inancial results an statistics o+ a #usiness are the results o+ the #usiness
o-eration, not the cause"
In this sense, #usiness analysis an invest$ent analysis have the o--osite
a--roach"
2inancial invest$ent $ay involve invest$ent activities such as shares,
-ro-erty an #ank e-osits"
In these situations, the -ercentage return $ay #e analyse an esti$ate in
avance"
The -ercentage return is usually +i3e, !hile the ollar a$ounts can vary"
2or e3a$-le, the sa$e -ercentage return is earne !hether one share is
-urchase or one hunre, an the sa$e -ercentage return is earne on #ank
e-osits o+ varying si@es"
The o--osite a++ect $ay occur in #usiness"
Business involves organising activities, $anaging -rouction an so +orth"
These activities -rouce a return a+ter the event, not a return -lanne in
avance"
In these situations, the ollar return is o+ten +i3e, !hile the -ercentage return
changes"
An invest$ent a--roach is so$eti$es taken to analysing #usinesses, rather
than a #usiness analysis a--roach"
In so$e cases an invest$ent analysis a--roach is relevant"
2or e3a$-le, this $ay a--ly in -urchasing a #usiness as an invest$ent,
!here the #usiness !ill #e continue as an ine-enent o-eration"
This a--roach $ay also a--ly to -ro9ects, !here the costs an sale o+ the
-ro9ect can #e analyse using a +inancial a--roach"
212
=o!ever, in the conte3t o+ continuous #usiness activity, the invest$ent
analysis a--roach can lea to ecisions that reuce the e++ectiveness o+ the
#usiness o-eration"
2or e3a$-le, it is so$eti$es assu$e that the return on a #usiness is a +i3e
-ercentage, rather than a +i3e ollar a$ount"
This is o+ten not the case"
Markets +or -roucts have a li$ite si@e, an e&ui-$ent an +acilities $ust
generally #e -urchase in se-arate large #locks"
Hner the invest$ent assu$-tion, it is so$eti$es assu$e that $ore $oney
can #e investe in a #usiness, an the aitional +uns !ill earn the sa$e
return as the e3isting o-eration"
The o--osite o+ten occurs, !ith the ollar a$ount staying +i3e an the
-ercentage return ecreasing, rather than the -ercentage return staying
constant an the ollar return increasing"
This ha--ens #ecause an invest$ent $oel is use +or revie!ing the #usiness
+igures, rather than a vie! #ase on a range o+ activities an o-erations that
-rouce a -articular outco$e"
An e3a$-le o+ this situation !oul #e a #usiness that evelo-e a s$all
success+ul o-eration"
The #usiness $ay then raise +uns to e3-an"
=o!ever, rather than the o-eration increasing, the e3isting ollar returns $ay
continue as #e+ore"
These returns !oul no! #e s-rea across a !ier ca-ital #ase, leaing to a
reuction in -ercentage returns"
%3-ansion o+ #usiness o-erations can #e one success+ully in a nu$#er o+
!ays, ho!ever si$-ly e-ositing aitional $oney into a #usiness oes not
generate an aitional return, in the !ay that -urchasing $ore shares or
e-ositing $ore +uns oes"
213
3.5.8. E9uit$ /un(ing vs. Business O5ners.ip
There are t!o alternative vie!s o+ e&uity +uns"
3.5.8.1. #eparation of o5ners.ip & ontrol
In the case o+ a -rivate #usiness o-eration, the o!ners o+ the #usiness also
o-erate the #usiness"
This $ay involve e$-loying a range o+ sta++ $e$#ers incluing -ossi#ly
$anage$ent sta++, ho!ever +una$entally the #usiness o!ners re$ain in
control o+ the #usiness itsel+"
In this scenario, the #usiness o-eration coul #e vie!e as the +ollo!ing
ste-sE
Inco$e is receive +ro$ custo$ers"
%3-enses are -ai"
The net i++erence accu$ulates as e&uity +uns !ithin the #usiness"
=o!ever, in so$e situations, a i++erent vie! o+ e&uity can #e a--lie"
This is so$eti$es kno!n as a se-aration #et!een o!nershi- an control"
In this vie!, the :#usiness; is se-arate +ro$ the shareholers or #usiness
o!ners"
Hner this vie!, raising e&uity +uns is si$-ly another source o+ +uns +or
the #usiness, as an alternative to raising e#t +uns"
This vie! is -articularly relevant to large -u#lic co$-anies, !here the e&uity
ca-ital is s-rea across a large nu$#er o+ iniviual shareholers, an the
shareholers are not -ersonally involve in $anaging the #usiness"
This vie! can also #e a--lie to -rivate #usiness structures, !hen a -assive
investor contri#utes +uns to an enter-rise #ut oes not !ish to #eco$e
-ersonally involve in o-erating the #usiness"
Hner this vie!, the #usiness o-erations coul #e vie!e as the +ollo!ing
ste-s"
210
7e#t is raise +ro$ leners an e&uity is raise +ro$ investors"
Assets are -urchase"
Inco$e is receive +ro$ custo$ers"
%3-enses are -ai"
Interest is -ai on e#t, an iviens are -ai to shareholers"
The vie! o+ e&uity as a source o+ ca-ital $ay also #e a--lie in the case o+
-rivate #usiness structures, !hen e&uity +uns are allocate +or a s-eci+ic
-ur-ose"
2or e3a$-le, e&uity $ay #e ke-t !ithin the #usiness as a #ase +or o-erating a
-ort+olio o+ traing risks, as a ca-ital #u++er to $anage cash +lo!, or as a
ca-ital #ase +or #anking or insurance activities"
3.5.8.2. T.e ost of apital
The vie! o+ e&uity an e#t as si$-ly t!o $ethos o+ +uning is the vie!
that is traitionally taken in -er+or$ing +inancial analysis o+ cor-orate
structures"
This leas to the calculation o+ a +igure kno!n as the :cost o+ ca-ital;, or
$ore accurately the :!eighte average cost o+ ca-ital;"
The section #eginning on -age 8)1 iscusses this issue in $ore etail"
%ssentially, this +igure uses the interest rate on the e#t, an an e3-ecte
return on e&uity, to calculate an average e++ective cost o+ raising #oth e#t
an e&uity +uns"
2or e3a$-le, a co$-any $ay have the +ollo!ing +igures
7e#t 100
%&uity 200
7e#t interest rate 1L
%&uity e3-ecte return 12L
21*
The !eighte average cost o+ ca-ital, or DA// value, $ay #e calculate
using the +ollo!ing +or$ula"
e!uity debt
return ected exp e!uity rate erest int debt
%ACC
+
+

200 100
12 200 1 100
+
+

.8 10
The #usiness !oul then #e vie!e as a +inancial structure that raise +uns
at the rate o+ 10"8 L, an generate a return e&ual to the :return on assets;
+igure"
The cost o+ ca-ital +igure is also o+ten use as a iscount rate in a net<-resent<
value analysis, an as a hurle rate +or the $ini$u$ rate o+ return re&uire
+ro$ a -ro9ect #e+ore the -ro9ect !ill #e a--rove"
A +e! -oints can #e $ae a#out this a--roach ho!ever"
The esti$ate o+ the :e3-ecte return; is usually #ase on a $oel o+ ca-ital
$arkets kno!n as the :ca-ital asset -ricing $oel;"
This is iscusse in section #eginning on -age 8))"
=o!ever, so$e vie!s $ay hol that an e3-ecte return $ay #e i++erent in
each situation, -articularly in the case o+ -ro9ects rather than trae
securities, an cannot #e eter$ine +ro$ the ca-ital asset -ricing $oel"
Also, the cost o+ e&uity a--roach $ay not #e relevant in situations !here the
#usiness o!ners irectly controlle the #usiness"
In this case, the vie! o+ e&uity +uns as an accu$ulation o+ assets $ay #e
$ore relevant"
=o!ever, the cost o+ ca-ital a--roach is !iely use in cor-orate analysis
an is an alternative vie! o+ #usiness o-erations"
21)
3.5.9. #ummar$ of margins & ratios
(ross $argin (sales I o-erating e3-enses) J sales
The -ro-ortion o+ sales inco$e retaine
a+ter -aying cash e3-enses"
%BIT $argin %BIT J sales
The -ro-ortion o+ sales inco$e that is
retaine a+ter -aying all o-erating costs,
incluing e-reciation"
4et -ro+it $argin (sales I net -ro+it) J sales
The net -ro+it as a -ro-ortion o+ sales
inco$e"
Interest cover %BIT J interest
The nu$#er o+ ti$es that gross cash +lo!
is a#le to cover interest -ay$ents"
Return on e&uity (RA%) net -ro+it J e&uity
The -ro+it return on the net assets o+ the
#usiness"
,o! values inicate that ca-ital is store
!ithin the #usiness #ut is not #eing
-rouctively use"
Return on assets (RAA) %BIT J assets
The o-erational return +ro$ the assets o+
the #usiness"
218
,o! values inicate that assets such as
-hysical e&ui-$ent are #eing use to
-roucing a return"
%arnings yiel net -ro+it J o-erational value
The return o+ the #usiness at the current
#usiness value"
(earing e#t J assets
The -ro-ortion o+ total assets that +une
+ro$ e#t, rather than e&uity invest$ent"
211
3.5.1". /inanial anal$sis terms
Availa#ility The -ercentage o+ ti$e that a +acility !as
availa#le +or use, !hether or not it !as actually
use uring that ti$e"
/a-acity utilisation The volu$e o+ -rouction uring a -erio, as a
-ercentage o+ the volu$e that !oul have #een
-rouce !ith the +acility o-erating at
$a3i$u$ ca-acity" This +igure is also use as
an econo$ic inicator, an is calculate across
the !hole econo$y #ase on total -rouction
+acilities"
7ivien yiel The ivien -ay$ent as a -ercentage o+ a
share -rice" This is si$ilar to the interest rate on
a #ank e-osit, !ith the earnings yiel also
incluing any ca-ital gro!th co$-onent in the
share -rice"
%arnings 4et -ro+it" A+ten e3-resse as earnings<-er<
shares, an use in valuations, such as a
valuation #ase on t!elve ti$es earnings"
%arnings yiel The net -ro+it ivie #y the #usiness value"
This !oul #e the invest$ent return i+ the
#usiness !as -urchase at the current value"
%BIT %arnings #e+ore Interest an Ta3" This is the
earnings +ro$ the o-erations o+ the #usiness,
#e+ore -ay$ents +or interest an ta3"
%BIT7A %arnings #e+ore Interest, Ta3, 7e-reciation an
A$ortisation" This is the gross cash +lo! o+ the
#usiness" This is the cash earnings +ro$
o-erations, #e+ore eucting e-reciation"
2i3e cost A cost that oes not vary !ith the volu$e o+
-rouction, such as #uiling rents, e-reciation,
$arketing an a$inistration e3-enses"
(earing The -ro-ortion o+ assets +une #y e#t, rather
than e&uity" =igh gearing levels $ulti-ly -ro+its
or losses"
(ross $argin The -ercentage o+ sales inco$e retaine a+ter
-aying cash e3-enses"
Interest cover The nu$#er o+ ti$es that gross cash +lo!
covers the interest -ay$ents"
45AT 4et 5ro+it A+ter Ta3" Also calle :earnings;
!ithin invest$ent analysis, or :net inco$e;"
5% 5rice %arnings ratio" This is the inverse o+ the
216
earnings yiel, an is !iely &uote +or liste
co$-anies"
RAA Return on Assets" The return on assets as a
-ercentage o+ the asset #ase" This +igure is
relevant to ca-ital<intensive inustries such as
$anu+acturing"
RA% Return on %&uity" The net -ro+it as a -ercentage
return on shareholerCs +uns"
'aria#le cost A cost that a--lies to each unit that is -rouce,
incluing ra! $aterials, +uel, an so on"
260
". Operating a business
".1. Services in the business environment
A !ie range o+ services are use !ith the #usiness environ$ent in the
course o+ o-erating a #usiness"
The +ollo!ing list escri#es so$e o+ the $a9or services an -arties that are
involve in #usiness activity"
Law*ers
,a!yers avise on legal issues, -re-are ocu$entation such as contracts an
trust ees, an arrange legal action through court hearings"
In the case o+ s$all transactions an enter-rises, a solicitor o-erating in
-rivate -ractice or !ithin a -artnershi- is o+ten use"
In the case o+ larger enter-rises, co$$ercial la! +ir$s are consulte"
,arge #usinesses generally have in<house legal sta++, ho!ever co$$ercial
la! +ir$s are consulte +or $a9or transactions, an +or conucting legal
action"
Chartered accountants
In the case o+ s$all enter-rises, accountants $ay -re-are +inancial
state$ents, ta3 returns an associate in+or$ation"
This in+or$ation is generally -re-are in<house #y larger organisations"
In the case o+ larger #usinesses, e3ternal accounting +ir$s o+ten -er+or$ the
auiting +unctions"
This involves an ine-enent revie! o+ the $ethos use to -re-are the
accounts, an a signe eclaration that the accounts have #een revie!e, an
that in the auitorCs o-inion, they have #een -re-are in accorance !ith the
accounting stanars"
So$e accounting +ir$s also -er+or$ #usiness analysis o+ +inancial results"
261
Contract services
/ontract services involve an on<going set o+ services, -er+or$e #y an
e3ternal organisation"
/ontract a$inistration $ay involve -rocessing -ay$ents +ro$ custo$ers,
raising invoices an state$ents, an $anaging creit collection"
/ontract co$-uter su--ort $ay involve su--ort o+ har!are an so+t!are
-ro#le$s"
This can range +ro$ irectly aressing iniviual -ro#le$s, to the co$-lete
har!are, so+t!are an in+or$ation technology in+rastructure #eing su--lie
#y the service -rovier"
/ontract $aintenance services are availa#le +or $aintaining e&ui-$ent in
so$e circu$stances"
,ndividual services
Iniviual services a--ly to s-eci+ic transactions, rather than an on<going
service agree$ent"
This inclues areas such as construction o+ ne! +acilities, avertising
ca$-aigns, co$-uter so+t!are evelo-$ent, esign o+ #ran logos, +unction
$anage$ent an so on"
Business "rokers
Business #rokers arrange the #uying an selling o+ s$all an $eiu$ si@e
#usinesses"
A #usiness #roker $ay also $aintain lists o+ iniviuals seeking to $ake
-rivate e&uity invest$ents in a #usiness, an #usinesses seeking -assive
e&uity investors"
aluers
'aluers -er+or$ valuations o+ assets"
'aluations are use +or -re-aring #alance sheets, +or assessing an asset as
security +or a loan, an !hen eciing !hether to #uy or sell an asset"
262
'aluations are -er+or$e +or -ro-erties an #usinesses"
S$aller +ir$s $ay value a s-eci+ic ty-e o+ asset, such as #usinesses, !hile
larger +ir$s $ay -er+or$ a !ier range o+ valuations"
Ather assets that can #e value inclue #ran na$es an trae $arks"
Banking
Banking -rovies +acilities +or holing #alances o+ cash !ithin #ank
accounts"
Banks also -rovie loans, arrange leasing o+ e&ui-$ent, -rovie che&ue an
electronic trans+er o+ -ay$ents, an -rovie +oreign e3change services"
Stock "rokers
Stock #rokers arrange the traing o+ shares through a stock e3change"
An iniviual cannot #uy shares irectly +ro$ another iniviual through a
stock e3change"
In orer to #uy or sell shares, an account is o-ene !ith a #roker"
The client then -laces an orer !ith the #roker to #uy or sell a certain nu$#er
o+ shares o+ a -articular co$-any, an the #roker -laces the orer in the
$arket"
Dhen this is $atche !ith a #uy or sell +ro$ the o--osite sie o+ the
transaction, a trae is e3ecute"
This is settle #et!een the t!o #rokers several ays later, !ith the cash an
share scri- #eing e3change on the settle$ent ay"
I+ the selling client +ails to eliver the share scri-, or the #uying client +ails to
-rovie the +uns, then the #roker ste-s in an +ills the other sie o+ the orer
irectly"
This $echanis$ e++ectively -rovies a guarantee settle$ent o+ each trae,
regarless o+ the actions o+ any -articular -erson #uying or selling shares"
263
The settle$ent $echanis$ is a $a9or reason +or the large volu$e o+ traing
that takes -lace through stock e3changes"
Stock #rokers also -rovie invest$ent avice on share invest$ent, organise
the -u#lic +loat o+ co$-anies on to the e3change, an $anage +uns irectly
+or clients"
,nvestment "ankers
Invest$ent #ankers -er+or$ services relate to raising ca-ital, an co$-any
takeovers"
This is in contrast to co$$ercial or retail #anks, !hich $aintain a #alance
sheet o+ loans an e-osits"
Invest$ent #anks arrange the -u#lic +loat an listing o+ co$-anies, -rovie
avice to co$-anies uring transactions such as cor-orate takeovers, an
$ay -rovie uner!riting services"
The invest$ent #ank $ay also assist in the -re-aration o+ a -ros-ectus +or a
+loat, e&uity or e#t issue"
Hner!riting #y an invest$ent #ank or stock #roker involves -roviing a
#ack<u- +acility uring a -u#lic +loat"
I+ the +ull set o+ availa#le shares is not -urchase #y the -u#lic, the #ank $ay
ste- in a -urchase the re$aining shares irectly"
This -arcel o+ shares is then generally trans+erre to $a9or institutional
investors uner a su#<uner!riting arrange$ent"
2ees are charge +or the uner!riting an su#<uner!riting services"
Advertising agencies
Basic avertising such as $ail<outs to e3isting clients an lea+lets can #e
organise irectly #y the #usiness"
=o!ever, $ore co$-le3 activities such as $aga@ine avertise$ents,
television co$$ercials, an $a9or avertising ca$-aigns are create #y
avertising agencies"
260
These agencies evelo- a $arketing ca$-aign, create the -resentation
$aterial, an organise the a--earance o+ the $aterial accoring to the ty-e o+
activity an the #uget that has #een s-eci+ie #y the client"
Promotion agencies
5ro$otions agencies organise an conuct -ro$otions o+ the #usinessCs
-roucts"
This $ay involve istri#uting sa$-le -roucts at $a9or events, an
organising activities ranging +ro$ concerts to en<o+<year +unctions"
So$e larger organisations also organise -ro$otions internally, !ith the sta++
involve in o-erating a +unction -rovie #y the -ro$otions agency"
".. 5inancial 6anagement
4.2.1. +as. flo5 management
/ash transactions are generally recore as they occur, !ith internal recors
#alance against #ank recors on a regular #asis"
Re-orts o+ inco$e, e3-enses an net cash +lo! $ay #e -rouce on a !eekly
or $onthly #asis"

Dorking ca-ital involves cash #alances hel at #anks an unuse availa#le
overra+t li$its"
4.2.1.1. +as. balanes
Ae&uate levels o+ !orking ca-ital nee to #e $aintaine to $eet une3-ecte
changes in cash +lo!"
Dhen $a9or e3-enses !ill #e ue +or -ay$ent on +uture ates, these shoul
#e inclue in o-erational -lans so that su++icient +uns can #e $aintaine to
$eet the -ay$ent !hen it #eco$es ue"
Hner an accrual accounting syste$, sales $ay #e #ooke as inco$e !hen
they occur, rather than !hen -ay$ent is receive"
26*
This can lea to highly $isleaing +inancial state$ents +ro$ a cash +lo!
-ers-ective"
In these cases, recors o+ -hysical cash levels also nee to #e ke-t, in
aition to the accounting recors o+ inco$e invoice to clients, an
e3-enses incurre"

4.2.1.2. +re(it terms
/reit is o+ten e3tene to custo$ers, -articularly in ealings !ith other
#usinesses"
Ter$s $ay inclue 10 ays, 30, )0, 60 or 110 ays in so$e cases"
The -ur-ose o+ a long creit ter$ is to allo! a custo$er to -urchase the
su--lies, $anu+acture a -rouct, sell the +inishe -rouct, an use the
-rocees +ro$ the sale to -ay +or the initial su--lies"
Dithout this creit, custo$ers !ith lo! availa#le cash #alances !oul not #e
a#le to -urchase the #usinessCs -roucts"
This arrange$ent is -articularly relevant to seasonal #usinesses that $ay
have one large sale -erio uring the year"
A long creit ter$ $ay also a--ly in cases !here a large orer !as -rocesse
+or a s-eci+ic -rouction run, rather than regular $onthly orers as -art o+
continuous -rouction"
=o!ever, long creit ter$s can #eco$e a -er$anent +eature o+ a su--ly
arrange$ent !ith a custo$er"
,ong creit ter$s create $any -ro#le$s +or a #usiness, an in general, short
creit ter$s shoul #e use !herever -ossi#le"
2or e3a$-le, e3-enses $ust #e +une +ro$ !orking ca-ital, an a large
increase in orers $ay lea to insu++icient +uns i+ inco$e is not receive +or
an e3tene -erio o+ ti$e"
Also, conitions $ay change signi+icantly over the -erio o+ the creit, !ith
sales rising or +alling, an the elay #et!een the cause<an<e++ect o+ the
invoicing an -ay$ent $ay reuce the +le3i#ility o+ the #usiness to aa-t to
change conitions"
26)
/usto$ers $ay #uil u- a large value o+ outstaning accounts, !hich coul
a$age the #usiness i+ the custo$er e+aulte on -ay$ent"
Dith short creit ter$s, a custo$er e+ault !oul #e recognise &uickly an
$ay result in a s$aller loss"
Also, a long creit -erio leaves a greater sco-e +or -ro#le$s evelo-ing
!ithin the custo$er, ranging +ro$ a eteriorating +inancial -osition to lost
recors, an these -ro#le$s $ay #e less likely !ith short creit ter$s"
5aying accounts that are ue on short notice as stanar -ractice allo!s +or
the -ossi#ility o+ te$-orarily e3tening -ay$ent in une3-ecte situations,
!hile !aiting until the en o+ creit ter$s as stanar -ractice oes not leave
any roo$ +or +le3i#ility !hen e3-ecte -ro#le$s arise"
4.2.1.3. +re(it olletion
7uring general #usiness o-erations, a -ercentage o+ custo$er -ay$ents !ill
not #e receive #y the ue ate"
An initial -rocess $ay involve re$iner letters an -ossi#ly tele-hone calls"
An aitional +ee is so$eti$es ae to overue accounts to cover
a$inistration costs"
I+ -ay$ent is still not receive a+ter these ste-s are taken, a e#t collection
agency can #e use"
These agencies o-erate a #usiness #ase on collecting overue accounts"
In cases !here the e#t is not recovere a+ter initial atte$-ts are $ae, the
#usiness can +ile an a--lication !ith a court to have the e#torCs a++airs
!oun u- through a #ankru-tcy -rocess"
In so$e cases, is-utes involving s$all a$ounts can #e hear in a s$all
clai$s tri#unal or other setting that involves a 9uge$ent o+ the clai$,
!ithout the cost an co$-le3ity o+ a +ull court hearing"
In the case o+ s$all a$ounts, +ailure to collect the e#t a+ter various ste-s are
taken $ay involve !riting o++ the e#t"
This involves acce-ting the e#t as lost"
268
An e3-ense is raise to recognise the loss, an the value o+ the :accounts
receiva#le; asset on the #alance sheet is reuce #y the sa$e a$ount"
A -rovision is generally inclue in the #alance sheet to allo! +or #a e#ts"
4.2.1.3.1. ,e(uing ba( (ebts
,osses ue to #a e#ts $ay #e li$ite in a nu$#er o+ !ays"
Pa*ment in advance
In the case o+ sales o+ -roucts to the general -u#lic, $ost #usinesses re&uire
-ay$ent in avance #e+ore goos are elivere"
=o!ever, in the case o+ services, an -roucts su--lie to #usinesses, an
invoice is o+ten raise a+ter the service has #een -er+or$e or the ite$ has
#een elivere"
In the case o+ varia#le usage o+ a -rouct, charging in avance $ay not #e
-ractical"
2or e3a$-le, tele-hone services an utilities such as electricity are charge at
the en o+ a -erio o+ usage"
In these cases, e+aults o+ -ay$ent $ay lea to iscontinuing the service"
Risks !ith +uture ealings !ith the sa$e custo$er $ay #e reuce #y
re&uiring a e-osit in avance, or -re<-ay$ent o+ +i3e a$ounts o+ su--ly"
Deposits4 partial pa*ment and progress pa*ments
In the case o+ elivery o+ large ite$s, such as ca-ital e&ui-$ent, e-osits or
-artial -ay$ent in avance can #e use to reuce the si@e o+ the loss i+ the
co$-lete -ay$ent is not receive"
In the case o+ long -ro9ects, -ay$ents at regular intervals, !hen -ro9ect
$ilestones are reache, or !hen -ro9ect stages are co$-lete $ay reuce the
chance o+ losses occurring ue to e+aults on -ay$ents #y clients"
Short credit terms
261
Short creit ter$s $ay -revent a single custo$er +ro$ accu$ulating a large
outstaning #alance, !hich $ay result in a large loss i+ the custo$er e+aults
on the -ay$ent"
Also, this a--roach $ay reuce the chance o+ -ro#le$s arising !ithin the
custo$erCs +inancial situation #et!een the ti$e that the -rouct is orere,
an the ti$e that the -ay$ent #eco$es ue"
(scrow accounts
In the case o+ large -ro9ect evelo-$ents, +uns $ay #e e-osite #y the
client in an escro! account hel #y a co$$ercial trustee, an release !hen
the -ro9ect has #een co$-lete or the e&ui-$ent has #een elivere"
This -rocess involves the client e-ositing the +uns in the na$e o+ a
co$$ercial trustee, #e+ore the #usiness co$$ences the -ro9ect"
Dhen the -ro9ect is co$-lete, the trustee then releases the +uns to the
#usiness in -ay$ent +or the -ro9ect evelo-$ent"
4.2.1.3.2. /atoring
In cases !here there is a large value o+ accounts receiva#le, a +actoring
service can #e use"
2actoring involves the +actor service -urchasing the accounts receiva#le at a
iscount +ro$ the #usiness"
In e++ect, the +actor service -ays the #usiness the value o+ the accounts
receiva#le i$$eiately, less an a$ount +or #a e#ts an the +actorCs +ees,
an takes over collection o+ the e#ts the$selves"
This $etho can #e use #y the #usiness to receive the inco$e +ro$ accounts
in a shorter ti$e, !hen there $ay #e a large value o+ accounts ue !ith long
creit ter$s"
Also, +actoring re$oves so$e o+ the a$inistrative #uren +ro$ the #usiness,
!hich is then hanle #y a s-ecialise agency"
266
4.2.1.3.3. #euritising (ebts
Money that is o!e to the #usiness is an asset, as this re-resents a -ay$ent
that $ay #e receive in the +uture"
In the case o+ large #usiness enter-rises, receiva#le a$ounts $ay so$eti$es
#e :securitise;"
This involves converting the e#t to a traa#le security, !hich a si$ilar in
nature to a share or a #on, an that can #e sol to receive the +uns #e+ore
the e#t is ue +or re-ay$ent"
In the case o+ short<ter$ accounts receiva#le, this -rocess generally involves
:#ank #ills;"
Dhere the custo$er is a large cor-oration that has a strong creit -osition, a
#ank $ay guarantee -ay$ent o+ the e#t in return +or a +ee"
The e#t then #eco$es kno!n as a #ank #ill, an can #e reaily sol in the
ca-ital $arkets"
The creit risk o+ a #ank #ill is #ase on the creit risk o+ the #ank, an has a
si$ilar creit risk to a irect #ank e-osit"
Bank #ills o not involve interest -ay$ents, #ut are sol at a iscount to their
+ace value, to re+lect an interest value over the -erio"
2or e3a$-le, a #ank #ill $ay have a +ace value o+ G100 an $ay involve a
-ay$ent o+ G100 in 60 ays ti$e"
The #ank #ill $ay #e sol +or G61, +or e3a$-le, !ith the G2 i++erence
#et!een the current cost an the +ace value re-resenting the interest return on
the invest$ent"
There is a large an li&ui $arket in #ank #ills in Australia, !ith the $a9ority
o+ #ank #ills involving ter$s o+ 60 ays"
(>> check etails o+ issuingJcusto$ers etc)
4.2.1.4. ,e(uing as. flo5 volatilit$
'olatile cash +lo!s $ay cause a nu$#er o+ -ro#le$s +or a #usiness"
300
A large #u++er o+ ca-ital $ay have to #e $aintaine to s$ooth rises an +alls
in +uns ue to the ti$ing o+ cash +lo!s"

Raising e#t $ay #e i++icult, an the e#t ca-acity o+ the #usiness $ay #e
reuce, !ith lo!er levels o+ e#t #eing a#le to #e su--orte than e&uivalent
#usinesses !ith $ore sta#le cash +lo!s"
Also, -lanning s-eci+ic events, or eter$ining likely ti$e +ra$es +or #usiness
evelo-$ent $ay #e $ore i++icult, as ti$e+ra$es $ay #e less certain than
!ith a #usiness having sta#le cash +lo!s"
A nu$#er o+ ste-s $ay #e -ossi#le to reuce the volatility o+ cash +lo!s"
These coul inclue so$e o+ the +ollo!ingE
/hanging lu$-<su$ -ay$ent arrange$ents to -ay$ents #ase on
instal$ents, such as -rogress -ay$ents through a -ro9ect
evelo-$ent"
Reucing creit ter$s o++ere to custo$ers"
Incluing e-osits +ro$ custo$ers in aition to -ay$ent on
elivery"
5er+or$ing several s$all -ro9ects rather than a single large -ro9ect"
Hsing heging $ethos to reuce volatility ue to +oreign e3change
rates !ith i$-orts or e3-orts"
Altering the #usiness to -er+or$ several i++erent activities"
4.2.1.4.1. Diversifiation
5er+or$ing several activities $ay have s$oothing e++ect on cash +lo!s, an
reuce -ro#le$s !ith situations !here a -erio o+ high inco$e occurs,
+ollo!e #y long -erios o+ lo! inco$e"
301
The e++ect o+ -er+or$ing several ine-enent activities is illustrate in the
+ollo!ing ta#le"
This ta#le sho!s the volatility o+ the total #usiness inco$e, co$-are !ith
the volatility o+ an iniviual activity"
$eduction in risk or volatilit* with diversification
=umber
of
'tivities
:olatilit$
1 1""<
2 71<
3 58<
4 5"<
5 45<
1" 32<
1"" 1"<
1""" 3<
Ta#le 1
This ta#le illustrates that s-litting the #usiness into t!o ine-enent activities
!oul reuce the volatility #y al$ost one<thir, to 81L"
A-erating +our se-arate activities !oul reuce the volatility to one<hal+ o+
the original volatility"
This e++ect $ay also a--ly to other situations !here a single event in s-lit
into several se-arate events"
2or e3a$-le, this ta#le $ay illustrate the reuction in risk that $ay occur
!hen a #usiness o-erates !ith a !ie client #ase, rather than !ith one or t!o
large clients"
This analysis is #ase on a statistical +or$ula"
302
This a--roach assu$es the +ollo!ing three -ointsE
The activities all have the sa$e volatility o+ inco$e"
The activities are ine-enent, !ith each one changing rano$ly,
ine-enently o+ the other activities"
The #usiness inco$e is s-lit evenly across all the activities"
Dhen these conitions are $et, the volatility reuces to the +ollo!ing
+or$ula"
items of number
volatility individual
volatility total
2or e3a$-le, the volatility o+ each iniviual risk $ay #e 1*L"
In the case o+ 10 risks, the total volatility coul #e calculate using the
+ollo!ing e3a$-le"
10
1*
volatility total
2 3
10
.

.1 3
This -rinci-le is kno!n as :iversi+ication;, an is one o+ the $ain -rinci-les
use in #usiness an +inance"
This a--roach is use to reuce the risk or -ort+olios o+ insurance -olicies,
#ank loans, an invest$ent -ort+olios"
In the case o+ general #usiness activities, s-eci+ic +igures coul not #e
a--lie"
303
=o!ever, the e++ect coul still #e ra$atic in so$e cases"
2or e3a$-le, in a seasonal #usiness that o-erate $ainly in su$$er,
e3-aning into another su$$er activity !oul have little i$-act on
volatility"
=o!ever, e3-aning into a !inter activity, as !ell as the e3isting su$$er
activity, coul have a large i$-act on the sta#ility o+ the #usiness inco$e
through the year"
Si$-ly e3-aning a #usiness into another area that !as ine-enent o+ the
e3isting o-erations coul have a sta#ilising i$-act on cash +lo!"
+ocus4 efficienc* and e%cessive diversification
The iversi+ication conce-t !as the -rinci-le #ehin the large iversi+ie
conglo$erates that !ere create in the 1610Cs"
=o!ever, in that case, the $oel !as not -articularly success+ul"
The o-erations inclue o@ens, an in so$e cases hunres, o+ se-arate
#usiness o-erations"
Dhen this ha--ene, there !as little sco-e to -ro-erly $anage an evelo-
each iniviual #usiness"
In $any cases, the $ost success+ul #usiness a--roach is to +ocus the +ull
resources o+ the #usiness on a single activity or o-eration, an si$-ly acce-t
the volatility that $ay #e associate !ith that a--roach"
5rouction is generally $ost e++icient !hen a large volu$e o+ a si$-le
-rocess is -er+or$e, rather than a !ie range o+ iniviual activities"
Positive and negative risk
7iversi+ication reuces volatility"
In the conte3t o+ #usiness an invest$ent, this is generally a -ositive
evelo-$ent"
=o!ever, !hile this reuces the chance o+ $a9or negative returns, it also
reuces the chance o+ $a9or -ositive returns"
300
In a statistical sense, this is -urely sy$$etrical"
In other ter$s, the chance o+ a -ositive return is reuce #y e3actly the sa$e
a$ount as the chance o+ a negative return"
Average returns
A se-arate e++ect relates to the average returns"
Dhen a range o+ se-arate ite$s are co$#ine, so$e !ill have a -ositive
return, so$e !ill have a negative return, an so$e !ill have average returns"
/o$#ining these together tens to lea to the total a$ount having an average
return"
This is no accient"
This e++ect occurs #ecause, !hen all ite$s are inclue, the total $ust e&ual
the average"
In +act, this is the e+inition o+ the average"
The i$-lication o+ this +or #usiness an invest$ent is that aing a large
nu$#er o+ activities, #usiness units, -roucts or other ite$s into a $i3 !ill
ten to -rouce return that +alls to!ars the average, unless care+ul selection
an $anage$ent o+ the co$#ination is carrie out"
Although there are isavantages to iversi+ying into se-arate -roucts o+
activities, this a--roach $ay #e relevant to seasonal inustries, an cyclical
inustries that involve unsta#le -atterns o+ sales"
4.2.1.4.2. +alulating volatilit$
In the case o+ #usiness +inances, a s$all nu$#er o+ iniviual +igures are
generally involve"
This $ay li$it the use o+ statistical analysis $ethos"
=o!ever, !hen a series o+ +igures are availa#le, such as the $onthly cash
+lo! +igures over a t!o year -erio, the volatility o+ the cash +lo! coul #e
assesse using $athe$atical a--roaches"
30*
This !oul ena#le a tren in volatility to #e eter$ine"
This a--roach $ay #e relevant to #usiness o-erations that have reasona#ly
sta#le o-erations over a long -erio o+ ti$e, !ith volatility graually
increasing or reucing"
The $ost co$$on $easure o+ volatility is the statistical $easure kno!n as
the :stanar eviation;"
The stanar eviation is a $easure o+ ho! !iely is-erse a set o+ nu$#er
are"
In the case o+ a ata series o+ si$ilar values, the stanar eviation $ay #e a
lo! +igure"
In the case o+ nu$#ers that vary !iely, the stanar eviation $ay #e large"
The stanar eviation can #e consiere to #e si$ilar to the average
eviation +or each ata -oint +ro$ the average value"
Strictly s-eaking, it is calculate as the s&uare root o+ the average s&uare
eviation +ro$ the average"
A stanar eviation calculation +unction is availa#le on $ost -ocket
calculators that inclue statistical +unctions, an in co$-uter so+t!are such as
s-reasheet -rogra$s"
2or e3a$-le, the +ollo!ing ta#le contains a list o+ cash +lo!s"
The average $onthly cash +lo! +or the -revious t!elve $onths is liste,
along !ith the stanar eviation over the year"
The average $onthly cash +lo! re$ains constant at aroun 1,000"
2or +irst t!elve $onths, !ith average !as 661, !ith a stanar eviation o+
12"
This is roughly e&uivalent to suggesting that the cash +lo!s, on average, !ere
a#out 12 $ore or 12 less than the central -oint o+ 661"
=o!ever, the ta#le also sho!s that the volatility is steaily increasing"
By the en o+ the thir year, the stanar eviation ha risen +ro$ 12 to
a#out 11"
30)
This increase in volatility $ay not #e o#vious si$-ly +ro$ vie!ing the list o+
ra! +igures"
A change in volatility such as this $ay re&uire an increase in !orking ca-ital
levels to avoi the risk o+ having insu++icient +uns to $eet -ay$ents, or
so$e other revie! o+ current o-erations an -rocesses"
308
+as. 'verage #tan(ar(
/lo5 Deviation
>an 1 1?""3
/eb 1 987
-ar 1 984
'pr 1 998
-a$ 1 1?"11
>une 1 1?""7
>ul$ 1 1?"1"
'ug 1 98!
#ep 1 1?"11
Ot 1 1?""9
=ov 1 988
De 1 98" 998 12
>an 2 1?""4 998 12
/eb 2 995 999 12
-ar 2 1?"2" 1?""2 13
'pr 2 1?"18 1?""3 12
-a$ 2 1?""1 1?""3 12
>une 2 1?"13 1?""3 13
>ul$ 2 99! 1?""2 13
'ug 2 1?"15 1?""4 13
#ep 2 1?"15 1?""5 12
Ot 2 1?"18 1?""5 13
=ov 2 1?"14 1?""7 13
De 2 991 1?""8 13
>an 3 997 1?""8 1"
/eb 3 975 1?""! 14
-ar 3 1?"1" 1?""5 13
'pr 3 1?"14 1?""5 13
-a$ 3 983 1?""3 14
>une 3 971 1?""" 17
>ul$ 3 98" 999 17
'ug 3 988 99! 17
#ep 3 1?"22 997 18
Ot 3 975 993 18
=ov 3 989 991 17
De 3 982 991 1!
301
4.2.2. /un(ing an( apital management
/a-ital is a large #lock o+ $oney"
In a $ore general sense, ca-ital is a large #lock o+ value, an $ay #e store
in the +or$ o+ cash, a -hysical asset such as a #uiling, or an intangi#le asset
such as a -atent"
/a-ital is use !ithin #usinesses +or various -ur-oses"
This inclues -urchasing assets such as e&ui-$ent, +uning -ro9ect
evelo-$ents, an +uning loss<$aking situations such as the start<u- -hase
o+ a ne! #usiness"
Dorking ca-ital is the #u++er o+ +uns that is $aintaine to $eet ti$ing
-ro#le$s !ith general o-erating cash +lo!, !here -ay$ents an inco$e $ay
arrive at rano$ ti$es, an -ay$ents $ay have to #e $ae #e+ore inco$e is
receive"
4.2.2.1. #ouring apital
/a-ital is source in t!o !ays"
7e#t involves #orro!ing +uns"
Interest costs $ust #e -ai, an the e#ts $ust generally #e re-ai accoring
to a scheule"
Raising e#t oes not a++ect the o!nershi- or control o+ the #usiness"
%&uity is the net assets o+ the #usiness"
The net assets are the total assets o+ the #usiness, less any e#ts or other
lia#ilities"
%&uity ca-ital re+ers to +uns source +ro$ the #usiness o!ners, or hel
!ithin the #usiness an inirectly o!ne #y the #usiness o!ners"
Rasing e&uity involves trans+erring assets into the #usiness, !hich $ay co$e
+ro$ the e3isting #usiness o!ners or +ro$ ne! investors"
306
Raising ca-ital, +ro$ either e#t or e&uity, results in the total assets o+ the
#usiness increasing"
This involves trans+or$ing the #usiness into a larger enter-rise"
The net assets o+ the #usiness are only a++ecte #y raising or istri#uting
e&uity, not #y raising or re-aying e#t"
In the case o+ -u#lic co$-anies, raising e&uity oes not generally a++ect the
control o+ the #usiness"

In these cases, the shares are generally s-rea across a large nu$#er o+
investors, #oth #e+ore an a+ter the ca-ital raising"
In the case o+ raising e&uity in a -rivate #usiness structure, this $ay involve
the e3isting #usiness o!ners trans+erring aitional assets into the #usiness,
or it $ay involve #ringing ne! -arties into the o!nershi- an control o+ the
#usiness"
4.2.2.2. E9uit$ o5ners.ip vs e9uit$ apital
%&uity can #e vie!e in t!o i++erent !ays"
Ane -ers-ective vie!s e&uity as the o!nershi- o+ the #usiness assets"
An alternative -ers-ective vie!s e&uity +uns as a source o+ ca-ital, that is
raise as an alternative to raising e#t"
Both vie!s are si$-ly i++erent -ers-ectives on the sa$e situation, an
e&uity is #oth a source o+ ca-ital, an the o!nershi- o+ the #usiness assets"
=o!ever, each vie! $ay #e relevant in i++erent circu$stances"
The o!nershi- vie! $ay #e -articularly a--lica#le in the case o+ s$all
enter-rises, !hen -rivate an #usiness assets are co$#ine, an !hen a
#usiness structure is o!ne an o-erate #y a s$all nu$#er o+ iniviuals"
The ca-ital vie! $ay #e a--lica#le in the case o+ large -u#lic co$-anies,
!here the shares $ay #e s-rea across a large nu$#er o+ iniviuals, !hen
ca-ital is raise to +un activities such as #anking an insurance, an !hen
ca-ital is allocate +or -ur-oses such as !orking ca-ital or to -rovie a #ase
+or a risk -ort+olio"
310
4.2.2.3. Debt vs. E9uit$
There are a nu$#er o+ issues that $ay a++ect the ecision as to !hether e#t
or e&uity shoul #e raise !hen ca-ital is neee +or a -ur-ose such as
-urchasing an asset"
These inclue the +ollo!ing -oints"
Availa"ilit*
In so$e situations, e#t $ay #e easy to raise an e&uity $ay #e i$-ossi#le,
!hile at other ti$es, e&uity $ay #e easy to raise an e#t $ay #e i$-ossi#le"
In so$e circu$stances, $oest a$ounts o+ either e#t or e&uity coul #e
raise at !ill"
At other ti$es, neither e#t nor e&uity coul #e raise, an the #usiness
!oul have to survive using the resources that it currently ha, or #eco$e
insolvent an #e li&uiate"
The availa#ility o+ e#t or e&uity $ay e++ectively $ake the ecision as to
!hich one is use, regarless o+ other issues"
In the case o+ s$aller enter-rises, raising e&uity !oul involve sourcing
aitional +uns +ro$ the e3isting #usiness o!ners, or locating another
investor !ho !oul !ish to invest +uns in the #usiness"
Bringing aitional -arties into the control o+ the #usiness is a $a9or ste-,
an !oul usually only #e one !hen a ecision !as $ae to $ake a $a9or
change in the structure an o-erations o+ the #usiness"
Alternatively, the e3isting #usiness o!ners coul trans+er aitional -ersonal
assets into the #usiness"

=o!ever, in $any cases the $a9ority o+ a #usiness o!nerCs assets $ay
alreay #e hel !ithin the #usiness"
In the case o+ e#t +or s$all enter-rises, this !oul e-en on the traing
history an sta#ility o+ the #usiness, the ca-ital strength o+ the e&uity !ithin
the #usiness, an any collateral or guarantees that coul #e o++ere to leners"
311
In the case o+ larger #usinesses, raising aitional e&uity !oul usually #e
straight+or!ar unless the co$-any !as in e3tre$ely serious +inancial
trou#le"
Raising e&uity to sta#ilise a co$-any that ha eteriorate into a generally
-oor o-erating conition is not unco$$on in the case o+ large enter-rises"
In the case o+ e#t, the availa#ility o+ e#t !oul e-en on the sta#ility o+
the #usiness"
I+ the #usiness !as o-erating success+ully, raising #ank e#t !oul usually
not #e i++icult, unless the co$-any alreay ha a high level o+ e#t"
A #usiness o-erating at a loss, or in -oor +inancial conition, $ay have
trou#le raising aitional #ank e#t or rolling over e3isting arrange$ents"
Raising e#t +ro$ the general -u#lic #y issuing #ons is usually only
-ractical +or very large co$-anies in a strong +inancial -osition"
Cash flow
7e#t generally involves regular interest -ay$ents"
These interest -ay$ents $ay #e a rain on cash +lo!"
Also, interest -ay$ents are a +i3e cost, an o not vary !ith the level o+
-rouction, or the level o+ sales"
This increases the chance that negative cash +lo! an +inancial istress $ay
occur uring ti$es !hen sales are slo!"
The risk to a #usiness ue to high e#t levels can #e signi+icant"
Insolvency an li&uiations are usually associate !ith high e#t levels"
This is ue to the high +i3e cash out+lo! re&uire to $eet interest -ay$ents"
I+ o-erating conitions eteriorate, there $ay #e insu++icient net cash +lo! to
$eet interest -ay$ents"
7iviens are o+ten -ai uring regular o-eration"
=o!ever iviens are o-tional, an can #e cancelle uring ti$es o+ cash
+lo! -ro#le$s o+ lo! e&uity resources"
312
Control
The choice #et!een e#t an e&uity is not generally a signi+icant issue +or the
control o+ a -u#lic co$-any"
In the case o+ a -rivate #usiness structure, this $ay have $a9or i$-lications"
7e#t allo!s the e3isting #usiness o!ners to retain o!nershi- an control o+
the #usiness"
Raising e&uity +ro$ other investors in this case !oul involve reucing the
o!nershi- to only -art o+ the #usiness, an i++iculties !ith ecision<$aking
an control $ay arise #et!een the e3isting investors an the ne! investors"
$eturns
In cases !here the return +ro$ the assets is greater than the interest rate on
e#t, raising e#t !oul increase the returns +ro$ the #usiness"
=o!ever, there are t!o li$itations to this"
2irst, i+ the return on assets is lo!er than the e#t interest rate, then
#orro!ing +uns !oul lea to a reuction in net -ro+it"
Also, the gearing a++ect $agni+ies losses, as !ell as -ro+its"
I+ a #usiness !ith a high e#t level entere a -erio o+ slo! sales, the e&uity
ca-ital coul #e &uickly erase, an the #usiness coul #eco$e insolvent"
$isk
Raising e#t instea o+ e&uity increases the risk to the #usiness"
This is ue to the cash +lo! -ro#le$s that coul #e cause #y the interest
-ay$ents, an also ue to the gearing e++ect, !hich increases the rate o+
losses uring a -erio o+ lo! activity"
De"t & ()uit* mi%
313
/onsiering the avantages an isavantages o+ e#t an e&uity, $ost
general #usiness o-erations use a $i3 o+ #oth"
/o$$on gearing ranges are e#t levels o+ 20L to *0L o+ total assets, !ith
the re$aining *0L to 10L #eing e&uity +uns"
This allo!s the #ene+its o+ e#t to #e realise, !ithout -lacing the #usiness at
e3cessive risk"
4.2.2.4. +apital ratios
Gearing
The s-lit #et!een e#t an e&uity !ithin the #usiness is generally $easure
using a :gearing; ratio"
The ratio o+ e#t to e&uity is so$eti$es use"
Another co$$on a--roach is a gearing ratio #ase on the level o+ e#t as a
-ercentage o+ total assets"
This value can #e calculate using the +ollo!ing +or$ula"
assets
debt
gearing
2or e3a$-le, a gearing ratio o+ 20L in this case !oul inicate that 20L o+
the assets !ere +une !ith e#t, an 10L !here +une !ith e&uity"
In this e3a$-le, the e&uity value !oul #e e&ual to +our ti$es the e#t value"
In the case o+ a #usiness !ith G30 o+ e#t an G100 o+ assets, the gearing
ratio !oul #e 30L"
(earing ratios in the range o+ 20L to *0L are co$$on +or general #usiness
o-erations"
Start<u- o-erations an #usinesses !ith highly unsta#le inco$e $ay not have
any e#t at all"
310
At the other e3tre$e, assets !ith highly sta#le cash +lo!s, such as toll roas,
are o+ten hel !ithin structures having very high gearing levels"
2or e3a$-le, a gearing rate o+ 60L !oul i$-ly that nine ollars o+ e#t !as
#orro!e +or each ollar o+ e&uity hel"
,nterest cover
Survival in the short an $eiu$ ter$ is $ainly a cash +lo! issue, not a
-ro+it issue"
5ro+it inclues the rise or +all in the value o+ assets, as !ell as the e++ects o+
cash +lo!"
7e#t -ay$ents, ho!ever, can only #e $et +ro$ cash holings"
The :interest cover; ratio is a ratio that $easures the -ro-ortion o+ cash +lo!
that is use to $eet e#t -ay$ents"
A lo! interest cover ratio inicates that a large -ro-ortion o+ net cash +lo! is
#eing use to cover interest -ay$ents"
This $ay suggest that e#t levels are too high, an that the #usiness is at risk
o+ negative cash +lo! an insolvency i+ o-erating conitions eteriorate"
The interest cover ratio $ay #e calculate using the +ollo!ing +or$ula"
paid erest int net
tax & erest int before Earnings
er cov Interest
An interest cover ratio o+ * !oul suggest that 20L o+ cash +lo! !as
re&uire to $eet e#t -ay$ents"
Although the interest cover ratio varies greatly e-ening on the ty-e o+
#usiness an the inustry, +igures o+ less than * $ay inicate that the
#usiness is at risk o+ cash +lo! -ro#le$s i+ o-erating conitions eteriorate"

(earing ratios are o+ten use to asses !hether the e#t level o+ a #usiness is
too high in a structural sense"
31*
=o!ever, cash +lo! ratios such as interest cover are a $ore accurate guie as
to !hether the #usiness is at risk o+ +inancial istress"
4.2.2.5. Debt
4.2.2.5.1. 7ses of (ebt
7e#t involves #orro!ing $oney"
7e#t is !iely use in #usiness"
Most #usinesses have so$e e#t, an $any #usiness activities cannot #e
conucte e++ectively !ithout the use o+ e#t"
,arge su$s o+ $oney $ay #e re&uire +or the -urchase o+ e&ui-$ent,
#uiling +acilities, +uning -ro9ects an general e3-ansion o+ the #usiness"
This ca-ital can #e source in t!o !ays"
Money can #e raise as e#t"
Alternatively, e&uity +uns can #e source +ro$ the e3isting #usiness o!ners
or +ro$ other investors"
Raising e&uity is not al!ays -ossi#le, as in $any cases investors !ho have
an interest or !illingness to invest $oney in the #usiness cannot #e +oun"
Also, sourcing e&uity +uns involves giving u- -artial o!nershi- an control
o+ the #usiness to other -arties"
In the e3tre$e case, this $ay lea to the original #usiness o!ners loosing
control o+ the #usiness, an eventually !ithra!ing +ro$ the #usiness
o-eration"
The use o+ e#t is also i$-ortant +ro$ a ca-ital $anage$ent -ers-ective"
The returns +ro$ a #usiness are generally o-ti$ise !hen a -articular $i3 o+
e#t an e&uity +uns is use"
In general #usiness o-erations, e#t is o+ten in the range o+ 20L to *0L o+
total assets, !ith the re$aining +uns #eing e&uity +uns"
31)
The e++ective use o+ e#t is an i$-ortant issue in the o-eration an
evelo-$ent o+ a #usiness"
4.2.2.5.2. #oures of (ebt
4.2.2.5.2.1. 'ssoiate( parties
7e#t is so$eti$es raise irectly +ro$ -arties associate !ith the #usiness"
This $ay inclue loans +ro$ relatives, an loans +ro$ the e3isting #usiness
o!ners to the #usiness itsel+"
This -articularly occurs uring the start<u- -hase o+ s$all enter-rises"
4.2.2.5.2.2. 3ersonal len(ing
5ersonal lening involves #orro!ing +ro$ #anks an other organisations as a
-ersonal #orro!ing arrange$ent"
This $ay involve -ersonal loans, $ortgages against -ro-erty, an other
+or$s o+ -ersonal lening"
This a--roach is o+ten use +or +uning -art<ti$e #usiness activities, an +or
raising +uns +or the start<u- -hase o+ a s$all enter-rise"
5ersonal lening is generally only availa#le to iniviuals !ho have a sta#le
inco$e"
This $ay #e a salary +ro$ a +ull<ti$e or -art<ti$e occu-ation, or so$e other
source o+ regular inco$e"
Hnsecure lening is availa#le +or s$all a$ounts, !hile large loans generally
re&uire security, such as a $ortgage against a -ro-erty"
The a$ounts that are loane are generally calculate as a $ulti-le o+ the
availa#le inco$e"
2or e3a$-le, a $ortgage loan $ay #e a--rove u- to a si@e that results in the
re-ay$ents #eing less than 2*L o+ the gross salary"
318
,onger ter$ loans have s$aller regular re-ay$ents than short ter$ loans,
an resiential $ortgages o+ten have ter$s o+ longer than 20 years"
4.2.2.5.2.3. Ban6s
Banks are the source o+ $ost #usiness lening, a-art +ro$ the very largest
organisations, !ho access the ca-ital $arkets irectly"
Ma9or #ank +acilities inclue the +ollo!ingE
Averra+ts A +loating loan #alance, general attache to a che&ue
account, that allo!s -ay$ents to #e $ae in avance o+
receiving inco$e to $anage ti$ing i++erences in cash
+lo!"
,easing A loan attache to the -urchase o+ an ite$ o+ e&ui-$ent"
The e&ui-$ent is use as security +or the loan"
,oans Stanar #ank loans" 2or e3a$-le, a +ive year loan !ith
interest -aya#le $onthly an the -rinci-al re-ai on the
$aturity ate" A loan $ay #e secure against an asset such
as a -ro-erty, or $ay #e unsecure"
Business overra+ts are co$$on, an once a regular -attern o+ inco$e an
e3-ense -ay$ents ha #een esta#lishe, overra+ts $ay nor$ally #e
e3tene !ithout great i++icultly"
,oans $ay re&uire collateral such as a $ortgage on a -ro-erty, or -ersonal
guarantees, unless the #usiness has e&uity ca-ital an a sta#le -ositive cash
+lo!"
In the case o+ general #usiness lening, #anks !oul nor$ally e3ten e#t
+acilities u- to a level that !as e&ual to the a$ount o+ e&uity ca-ital, as long
as the #usiness cash +lo! !as -ositive an reasona#ly sta#le"
In these circu$stances, the value o+ the #usiness assets coul +all #y one<hal+
#e+ore losses occurre on the loan #alance"
A lease $ay #e easier to arrange than a stanar #ank loan, as a lease is a
secure +or$ o+ lening"
311
Also, a lease is e++ectively an a$ortising loan, !hich is a lo!er risk +or$ o+
lening than the se-arate interest<only an -rinci-al re-ay$ent structure that
is co$$on in #usiness e#t"
4.2.2.5.2.4. 8easing an( /inane ompanies
2inance co$-anies -er+or$ lening services, ho!ever they are not license
to acce-t e-osits +ro$ the general -u#lic in the !ay that #anks are a#le to"
The +uns use #y +inance an leasing co$-anies are source +ro$ investors
an !holesale ca-ital $arkets"
2inance co$-anies s-ecialise in leasing arrange$ents !ith e&ui-$ent, an in
retail creit involving ite$s such as goos #eing -urchase #y a custo$er #y
instal$ents"
Interest rates $ay #e higher on these loans than #ank loans, as +inance
co$-anies ten to o-erate in a higher<risk -art o+ the loan $arket, an they
o not have access to the lo!<interest +uns that #anks hol in che&ue
accounts an other +acilities"
In other cases, interest rates $ay #e the sa$e or lo!er than #anks, ho!ever
there $ay #e a !ie variation #et!een i++erent arrange$ents, -articularly in
the case o+ s$all transactions"
Also, the total cost o+ the ite$ involves #oth the -urchase -rice an the
interest rate"
A high interest rate $ay re-resent a lo! total -rice i+ the sale -rice itsel+ is
lo!, !hile a lo! interest rate $ay a--ly to a high total -rice i+ the sale -rice
itsel+ !as high"
=o!ever, !hen the creit ter$ e3tens over a -erio o+ $ore than one or t!o
years, the interest rate $ay have a signi+icant i$-act on the total cost o+ the
-urchase"
In the case o+ large transactions, such as the leasing o+ large ite$s o+
e&ui-$ent, interest rates are generally highly co$-etitive across a #roa
range o+ leners, an the interest rate $ay #e a s$all $argin a#ove !holesale
interest rates"
316
4.2.2.5.2.5. +ustomer pa$ments b$ instalments
A +inance co$-any can #e use to o++er an alternative -ay$ent $etho to
custo$ers"
In the case o+ large transactions, the #usiness $ay hanle the +inancing issues
involve in o++ering to acce-t -ay$ent in several instal$ents"
In the case o+ sales to the general -u#lic, ho!ever, the #usiness itsel+ oes
not usually hanle the +inancing arrange$ents irectly"
This is a s-ecialise area involving raising +uning, interest calculations an
a$inistration, collecting overue accounts, #a e#ts an so +orth"
In this arrange$ent, the +inance co$-any -ays the #usiness the +ull su$ +or
the sale o+ the ite$ !hen the sale occurs, an then collects the instal$ents
irectly +ro$ the custo$er"
7e-ening on the arrange$ent, the a$ount -ai $ay #e the sa$e as the +ull
sale -rice, or it $ay inclue a iscount"
2or e3a$-le, a #usiness $ay o++er interest<+ree -ay$ents +or the -urchase o+
an ite$"
This is e&uivalent to o++ering a iscount on the ite$ an selling it at a lo!er
-rice, ue to the interest saving #y the custo$er"
In these cases, the +inance co$-any !oul -ay a reuce a$ount to the
#usiness, to allo! the +inance co$-any to collect the e&uivalent interest
a$ount, !hile the #usiness !oul inclue this iscount as a cost o+ achieving
a sale at a lo!er $argin"
=o!ever, although interest<+ree ter$s have a +inancial value, this $ay also
#e #uilt into a higher sale -rice, an so a irect co$-arison !ith co$-etitorCs
-roucts !oul have to consier the sale -rice as !ell as the -urchase ter$s"
Although in general the cost o+ the +inance !oul #e e&ual to the i++erence
in the sale -rices, this $ay #e a valua#le service to o++er to custo$ers"
This $ay occur +or t!o reasons"
5ay$ent #y instal$ents reuces the cash +lo! #uren !ith $aking a single
large -ay$ent, #oth #y a #usiness or #y an iniviual"
320
Also, this +inancing a--roach $ay involve less i++icultly in creit
assess$ent an inconvenience than the custo$er atte$-ting to source a loan
using other $ethos o+ lening"
This +inancing a--roach is co$$only o++ere in sales o+ large ite$s to the
general -u#lic"
4.2.2.5.2.!. :en(or /inaning
'enor +inancing occurs !hen the seller o+ an ite$ -rovies the +inancing
ter$s"
This generally involves acce-ting -ay$ent in instal$ents over a -erio o+
ti$e"
Interest costs are generally inclue !ithin the instal$ents, !ith the total
a$ount o+ the instal$ents #eing a larger +igure than the original -rice"
'enor +inancing is co$$on in the sale o+ #usinesses, an in the sale o+ large
ite$s o+ $anu+acture e&ui-$ent"
Interest rates $ay vary, ho!ever in the case o+ large ite$s the interest rate
$ay #e a co$-etitive +igure"
These transactions are generally conucte as a !ay o+ increasing the nu$#er
o+ sales o+ the e&ui-$ent, rather than a -ro+it<$aking e3ercise #ase on the
interest charges the$selves"
In the case o+ the sale o+ a #usiness, creit assess$ent o+ the #uyer $ay not
#e a $a9or issue, as the -ay$ents +or the #usiness -urchase !oul co$e +ro$
the cash +lo!s o+ the #usiness itsel+"
4.2.2.5.2.7. +apital mar6ets
Accessing the ca-ital $arkets irectly involves raising $oney +ro$ the
general -u#lic"
This involves the issue o+ a -ros-ectus"
2uns are then su#scri#e #y investors, an the #usiness -ays interest on the
e#t an re-ays the -rinci-al at a +uture ate"
321
Most +uns raise in this !ay are structure as #ons"
This generally involves regular interest -ay$ents, usually hal+<yearly, !ith
the -rinci-al re-ai in a lu$- su$ at the en o+ the -erio"
The interest rate is usually +i3e +or the -erio o+ the #on"
These #ons are so$eti$es liste +or traing on stock e3changes"
This allo!s an investor to sell the #on an recover their +uns #e+ore the
#on ter$ e3-ires"
=o!ever, i+ the general level o+ interest rates has risen or +allen since the
#on !as issue, the #on interest rate $ay #e $ore or less attractive than
current interest rates
In general a ca-ital gain or loss $ay occur i+ the #on is sol -rior to
$aturity"
This ca-ital gain or loss occurs regarless o+ !hether the #on is sol or not,
as the +i3e interest rate $ay #e higher or lo!er than the +loating interest
rates that are availa#le on a +uture ate"
Accessing the ca-ital $arkets irectly is generally only availa#le to large
organisations !ith sta#le #usiness o-erations"
/reit rating agencies such as MooyCs an Stanar . 5oors issue creit
ratings o+ #ons, incluing #ons issue #y govern$ents an large
cor-orations

These range +ro$ AAA #eing the highest grae, o!n to AA, AM, BB an a
series o+ other ratings, !ith lo!er ratings inicating a higher chance o+
e+ault"
4.2.2.5.2.8. >un6 bon(s
Funk #ons are #ons issue #y s$aller enter-rises, or #usinesses !ith
unsta#le inco$e"
These #ons carry a high interest rate, to co$-ensate +or the signi+icant
chance o+ a e+ault on the #on -ay$ents"
There is no evelo-e 9unk #on $arket in Australia"
322
Funk #ons $ay carry high interest rates, such as interest rates in the range o+
1)L to 20L, to co$-ensate +or the risk o+ e+ault on the #on -ay$ents"
It is very i++icult +or a #usiness to generate a return a#ove this level, !hich
!oul allo! it to raise ca-ital using 9unk #ons an +inance a -ro9ect that
-rouce a -ositive net return a+ter interest costs"
=o!ever, in the Hnite States, the 9unk #on $arket e3-ane ra-ily uring
the 1610Cs, an a large an li&ui 9unk #on $arket evelo-e"
2ollo!ing the stock $arket crash o+ 1618 an the recession o+ the early
1660Cs, $any co$-anies e+aulte on -ay$ent an the 9unk #on $arket
shrank consiera#ly"
A nu$#er o+ scanals !ere also involve at the height o+ the $arket, !hich
later ca$e to light +ollo!ing the colla-se o+ the $arket"
Funk #ons are still trae in the HS, on a $uch<reuce scale"
4.2.2.5.3. Borro5ing
In the sa$e !ay that a ecision to -urchase a -rouct is $ae #y the
custo$er, not the #usiness, the ecision to e3ten a loan is $ae #y the
lener, not the #orro!er"
,eners are naturally cautious"
At an interest rate o+ *L, it !oul take t!enty years to recover the initial
-rinci-al o+ a loan #y accu$ulating the interest -ay$ents"
I+ the #usiness -er+or$s !ell, the #ank or other lener oes not receive any
#ene+it"
Interest -ay$ents continue as #e+ore"
=o!ever, i+ the #usiness +ails an is li&uiate, a -artial or co$-lete loss o+
the loan ca-ital $ay occur"
Dithout the #ene+it o+ -ositive risk, leners generally are not !illing to
acce-t signi+icant negative risk either"
In $any cases a #usiness !ill not #e a#le to #orro! !hen it !oul !ish to"
323
=o!ever, various ste-s can #e taken in structuring an o-erating a #usiness
that $ay i$-rove the a#ility o+ the #usiness to raise e#t"

4.2.2.5.3.1. +ollateral
/ollateral involves the lener holing a $ortgage against a -hysical asset, as
security +or a loan"
This occurs in -ro-erty $ortgages, an leasing o+ e&ui-$ent"
In the case that the #usiness e+aults on the loan re-ay$ents, the lener can
then sell the asset to recover the +uns"
/ollateral is a $a9or issue in lening"
A loan arrange$ent that hols security over an asset is kno!n as a secure
loan, !hile a general loan to the #usiness is kno!n as unsecure loan"
Secure lening has a $uch lo!er risk than unsecure lening, -articularly i+
the loan is e&ual to only -art o+ the asset value, rather than the +ull asset value
such as a lease arrange$ent +or an e&ui-$ent -urchase"
I+ a #usiness can o++er an e3isting asset as collateral, or i+ the #usiness ties the
loan to the -urchase o+ a -hysical asset, then lening $ay #e e3tene #ase
on a reasona#ly sta#le cash +lo! strea$"
This is the case !hen a -ro-erty is -urchase using a loan, or !hen
e&ui-$ent is lease"
4.2.2.5.3.2. 1uarantees
In the case o+ general lening +or #usiness e3-ansion, #anks $ay o+ten
re&uire -ersonal guarantees +ro$ irectors, investors an -arties involve in
the #usiness"
This -articularly occurs !ith s$all enter-rises"
This issue oes not usually arise in $eiu$s si@e an large #usinesses, as
the assets !ithin the #usiness an the a$ounts o+ $oney #orro!e are
usually $uch larger than the -ersonal assets o+ the iniviuals involve"
320
A -ersonal guarantee ties the iniviualCs -ersonal assets to the loan"
I+ the #usiness e+aults on -ay$ents, then the iniviual $ust $eet the loan
re-ay$ents"
This is one $echanis$ #y !hich a #usiness insolvency can also lea to
-ersonal #ankru-tcy o+ the #usiness o!ners"
Although guarantees are o+ten given reluctantly, in so$e situations a ecision
$ust #e $ae as to !hether to -rocee !ith the loan on a guarantee #asis, or
!hether to a#anon the o-tion o+ #orro!ing at that ti$e"
Any -arty o++ering a guarantee +or a #usiness loan shoul generally consier
the situation care+ully, an assu$e that the !orst<case situation $ay occur, in
!hich case they !ill #e -ersonally lia#le to re-ay the +ull a$ount o+ the loan"
4.2.2.5.3.3. #tabilit$ of as. flo5
Sta#ility o+ cash +lo! an collateral are the t!o largest issues involve in a
lening ecision"
Sta#ility is a highly i$-ortant issue in assessing a #usiness loan"
A #usiness that has a steay level o+ $oest -ro+it is $uch -re+erre #y
leners to a #usiness that has high -ro+its +or -erios, +ollo!e #y shar-
ro-s in -ro+it"
Although the #usiness strategy cannot #e altere -urely +or the -ur-oses o+
#orro!ing, the issue o+ sta#ility an steay gro!th $ay have a general in-ut
to the evelo-$ent o+ the #usiness, in the conte3t o+ +uture #orro!ing"
2or e3a$-le, taking ste-s to reuce the volatility o+ cash +lo! $ay reuce
!orking ca-ital re&uire$ents, i$-rove the sta#ility o+ the #usiness, an $ake
raising e#t easier"
A sta#le cash +lo! over a -erio o+ ti$e $ay allo! the #usiness to carry a
signi+icant e#t #uren, !ithout a $a9or risk o+ insolvency evelo-ing"
Methos to s$ooth cash +lo!, such as -ay$ents in instal$ents an o-erating
several i++erent activities, $ay i$-rove the #usinessCs general +inancial
-osition an also $ake #orro!ing easier"
32*
4.2.2.5.3.4. +apital strengt.
The ca-ital strength o+ the #usiness involves the a$ount o+ e&uity +uns
retaine !ithin the #usiness, in -ro-ortion to the level o+ e#t an cash +lo!"
A-erating $argins $ay also #e relevant in assessing the risk o+ a e+ault
occurring on a loan ue to eteriorating conitions"
A #usiness in a strong ca-ital -osition $ay not su++er serious -ro#le$s in the
short ter$ i+ $argins shrank, sales ecline, inco$e -ay$ents !ere not
receive, or une3-ecte e3-enses arose"
The ca-ital strength o+ a #usiness can #e i$-rove using so$e o+ the
+ollo!ing a--roachesE
Retaining -ro+its !ithin the #usiness rather than -aying iviens"
Hsing short creit ter$s !ith custo$ers"
,easing e&ui-$ent an +acilities rather than s-ening e&uity
+uns"
Avoiing e3cessive ca-ital e3-eniture on ne! +acilities an
-ro9ects
Trans+erring -ersonal assets into the #usiness" This is kno!n as
:ca-italising the co$-any;"
4.2.2.5.4. Debt apait$
7e#t ca-acity is the level o+ e#t that can #e su--orte #y the #usiness
o-erations"
This is -ri$arily a cash +lo! issue, rather than a -ro+ita#ility issue"
7e#t ca-acity can #e $easure using the :interest cover; ratio, !hich is the
ratio o+ gross cash +lo! to the interest e3-ense"
2or e3a$-le, an interest cover ratio o+ three ti$es !oul inicate that the
gross cash +lo! !as three ti$es larger than the interest -ay$ents"
32)
The e#t ca-acity o+ a #usiness is highly e-enant on the sta#ility o+ the
cash +lo!s"
=igh gearing levels are use !ith sta#le an -reicta#le cash +lo!s, such as
-ro-erty an in+rastructure invest$ent"
2or e3a$-le, resiential -ro-erty loans o+ten have loan<to<valuation ratios o+
u- to 60L, inicating that nine ollars is #orro!e +or every ollar that is
investe"
7e#t ca-acity can #e i$-rove #y taking ste-s to reuce the volatility o+ cash
+lo!, an ensuring that the #usiness evelo-s along a continuous -ath, rather
than conucting rano$ transactions"
4.2.2.5.5. Debt strutures
7e#t involves $aking a series o+ -ay$ents"
These -ay$ents can #e structure in a !ie variety o+ i++erent !ays"
In $ost cases, a single -ay$ent is $ae +ro$ the lener to the #orro!er at
the #eginning o+ the loan ter$, an then a series o+ -ay$ents is $ae +ro$
the #orro!er to the lener"
More co$-le3 arrange$ents $ay a--ly in situations such as -ro9ect
+inancing, !hich $ay involve several -ay$ents in each irection at i++erent
-oints uring the -ro9ect"
4.2.2.5.5.1. 3rinipal & 4nterest vs. #truture( +as. /lo5s
7e#t structures can #e vie!e in t!o !ays"
The :-rinci-al . interest; vie! involves the loan having an outstaning
#alance"
Interest -ay$ents are #ase on the loan #alance outstaning at a -articular
-oint in ti$e"
328
7e-ening on !hether the -ay$ents $ae are less than, e&ual to, or greater
than the interest a$ount, the loan #alance $ay increase, stay level, or reuce
uring the ter$ o+ the loan"
The +inal loan -ay$ent involves the -ay$ent o+ the outstaning #alance, i+
any"
The alternative vie! oes involve a conce-t o+ a :loan #alance; or
:outstaning -rinci-al; a$ount, an oes not consier -rinci-al an interest
as se-arate -ay$ents"
Hner this vie!, the loan structure consists o+ a series o+ in+lo!s an
out+lo!s o+ i++erent si@es at i++erent -oints in ti$e"
The :internal rate o+ return; calculation can #e use to eter$ine the
e++ective interest rate o+ the loan structure"
This is the interest rate than sets the -resent value o+ all in+lo!s an out+lo!s
to @ero"
The cash +lo! a--roach is generally use in co$-le3 e#t structures an
+inancial $arkets transactions, !hile the -rinci-al<an<interest a--roach is
use+ul +or revie!ing #usiness lening"
%ach vie! is si$-ly a i++erent -ers-ective on the sa$e set o+ -ay$ents, an
there is no i++erence in a$ounts e-ening on !hich vie! is use to
inter-ret the -ay$ents"
2or e3a$-le, the -rinci-al<an<interest -ers-ective is use+ul +or revie!ing
the a$ount than !oul #e neee to ter$inate a loan $i<!ay through the
loan ter$, !hile the cash<+lo! a--roach is use+ul +or eter$ining the
e++ective interest rate o+ a set o+ -ay$ents"
4.2.2.5.5.2. Bon(s
Most #ons issue #y cor-orations an govern$ents +ollo! a si$ilar
-ay$ent structure"
This involves regular interest -ay$ents, usually hal+<yearly, !ith the
-rinci-al #eing re-ai in a lu$- su$ at the en o+ the -erio"
Ter$s usually range +ro$ 3 to 10 years +or cor-orate #ons, an u- to 20
years +or govern$ent #ons"
321
This structure is also availa#le +or #ank loans, in !hich case it is kno!n as an
:interest<only loan;"
This is a si$-le structure than has several avantages"
Interest -ay$ents are clearly se-arate +ro$ -rinci-al -ay$ents"
5ay$ents uring the ter$ o+ the #on are lo!er than the -ay$ents on an
a$ortising loan, !hich reuces the rain on cash +lo!"
Also, $any #usiness transactions are +una$entally #ase on iniviual
lu$-<su$ -ay$ents"
2or e3a$-le, $oney $ay #e raise to +un a evelo-$ent -ro9ect, the -ro9ect
$ay #e co$-lete, an then the +inishe -ro9ect $ay #e sol an the loan
$ay #e re-ai"
In circu$stances such as these, the re-ay$ent o+ the -rinci-al in a lu$- su$
$atches the sale o+ the +inishe -ro9ect"
This is in contrast to -ersonal situations, !hich usually o-erate on a
continuous #asis, rather than a lu$-<su$ #asis"
Businesses usually carry a sta#le level o+ e#t +or e3tene -erios o+ ti$e"
Interest -ay$ents are $ae on a regular #asis"
In the case o+ #ank lening, -rinci-al a$ounts $ay #e rolle<over on loan
$aturity ates"
Dith #ons issue to investors, ne! #ons are generally issue to ensure that
the total e#t level re$ains reasona#le sta#le"
This a--lies ue to the +act that the assets, incluing the #usiness o-erations
an e&ui-$ent that is regularly re-lace, also re$ain at a sta#le level"
In contrast, -ersonal lening o+ten involves assets that reuce in value, or in
the case o+ -ro-erty, e++ectively inclues a savings sche$e as !ell as interest
-ay$ents, so that the value o+ the -ro-erty is accu$ulate as the loan is
re-ai"
326
4.2.2.5.5.3. Disount seurities
7iscount securities are issue #y large co$-anies an govern$ents"
These are short<ter$ #orro!ings, !ith ter$s ty-ically #eing 30, )0, 60 or 110
ays"
4o interest is -ai uring the ter$ o+ these transactions"
An a$ount is #orro!e at the #eginning o+ the -erio, an then a larger
a$ount is re-ai at the en o+ the -erio, to inclue the interest co$-onent"
The ter$ :iscount; co$es +ro$ the +act that the +inal value, not the initial
value, is usually a +i3e a$ount, !ith the initial value #eing a iscount to the
+ace value"
2or e3a$-le, a short<ter$ #ill $ay #e issue !ith a +ace value o+ G10, an an
initial value o+ G6"183*"
:Bank #ills; are short<ter$ #ills issue #y co$-anies that have #een
enorse #y a #ank"
I+ the co$-any e+aults on the -ay$ent, the -ay$ent is $ae #y the #ank"
A +ee is charge #y the #ank +or -roviing this guarantee, an the security
itsel+ has the e&uivalent security o+ a #ank e-osit !ith that #ank"
These #ills are use +or creit in traes #et!een $eiu$<si@e an large
co$-anies"
The #ank #ill $arket is o+ten use #y co$-anies an invest$ent +uns +or
investing cash holings, rather than e-ositing the holings !ithin #ank
accounts"
4.2.2.5.5.4. 'mortising loans
An a$ortising loan structure involves a series o+ regular -ay$ents, !ith the
-rinci-al o+ the loan #eing reuce to @ero at the en o+ the loan ter$"
Most -ersonal lening is #ase on a$ortising loans"
330
A$ortising loans have higher re-ay$ents than interest<only loans, ho!ever
there is no nee to re-ay the -rinci-al in a lu$- su$ at the en o+ the loan
ter$"
In an a$ortising loan, the -ay$ents are a +i3e a$ount through the ter$ o+
the loan"
The -rinci-al o+ an a$ortising loan oes not reuce in a straight line"
%arly -ay$ents $ainly cover interest, !ith the -rinci-al eclining slo!ly,
!hile later re-ay$ents have a s$all interest co$-onent, !ith the -rinci-al
+alling ra-ily to!ars the en o+ the loan"
In the #usiness conte3t, a$ortising loans coul #e use+ul +or -urchasing
e&ui-$ent"
%&ui-$ent leases generally have an a$ortising -ay$ent structure"
The e&ui-$ent eclines in value over a -erio o+ ti$e"
I+ the ter$ o+ the loan is a--ro3i$ately e&ual to the li+e s-an o+ the
e&ui-$ent, then the ecline in the loan #alance !ill occur at a si$ilar rate to
the ecline in the value o+ the e&ui-$ent"
At the en o+ the loan ter$, #oth the loan an the e&ui-$ent !ill have a @ero
value"
This $ay #e a sa+er arrange$ent than an interest<only a--roach, as in this
case the risk arises o+ the assets eclining to @ero, leaving a large a$ount o+
e#t, #ut no assets or cash +lo! to su--ort the loan"
The +ollo!ing gra-h illustrates the ecline in the #alance o+ an a$ortising
loan through the ter$ o+ the loan"
In the case o+ straight<line e-reciation, or a $arket value that reuces in a
straight line, the asset value an the net value o+ the asset an the e#t is also
sho!n"
331
,mortising loan balance
*!"
*4"
*2"
"
2"
4"
!"
8"
1""
12"
8oan Balane
'sset :alue
=et value
Ta#le 2
4.2.2.5.5.5. /loating balanes
2loating e#t #alances occur in overra+ts an other at<call creit +acilities"
In these cases, the #usiness can !ithra! an e-osit -ay$ents at !ill"
The level o+ outstaning -rinci-al $ay rise an +all over ti$e, !ith the
interest #eing calculate on the level o+ -rinci-al o!ing at each -oint in ti$e"
2loating creits +acilities $ay #e use+ul +or $anaging variations in cash +lo!,
!here -ay$ents $ay #e re&uire #e+ore inco$e is receive, an as stan<#y
+acilities in case o+ une3-ecte e3-enses or cash +lo! -ro#le$s evelo-ing"
Averra+ts attache to #usiness che&ue accounts are a !iely use +or
$anaging cash +lo!"
332
4.2.2.5.5.!. +apitalise( interest
/a-italisation o+ interest occurs !hen re-ay$ents are not $ae uring the
ter$ o+ a $eiu$<tern or long<ter$ loan"
In these cases, interest is calculate on a regular #asis, an ae to the
-rinci-al a$ount"
The -rinci-al gro!s uring the ter$ o+ the loan, an interest costs also
increase as the interest is calculate on a higher -rinci-al a$ount"
The outstaning -rinci-al a$ount is then re-ai at the en o+ the loan ter$"
This is clearly a higher<risk a--roach than structures such as a$ortising
loans, #oth +or the lener an #orro!er"
Dith ca-italise interest, the a$ount o!ing increases uring the loan ter$"
Also, regular -ay$ents are not $ae"
In the case o+ a #on, +or e3a$-le, regular -ay$ents o+ interest are $ae"
This is generally #ase on the regular cash +ro$ the #usiness o-erations"
This structure ensures that, at a $ini$u$, the #usiness has the ca-acity to
$eet on<going interest -ay$ents"
=o!ever, !ith ca-italise interest, the risk arises that the #usiness !ill never
have the cash +lo! to -ay even the on<going interest costs, let alone re-ay the
-rinci-al"
=o!ever, ca-italisation o+ interest is a use+ul structure in a nu$#er o+
circu$stances"
This generally a--lies !hen no inco$e is receive uring the ter$ o+ the
loan"
2or e3a$-le, e#t $ay #e raise to +un a evelo-$ent -ro9ect"
The $oney raise !oul then #e use to -ay the e3-enses o+ the
evelo-$ent"
Interest on the e#t $ay #e ca-italise, an the loan !oul #e re-ai at the
en o+ the ter$ !hen the +inishe -ro9ect !as sol"
333
5aying interest uring the loan ter$ !oul #e -ointless in this case, as this
!oul si$-ly involve -aying #ack +uns to the lener that !ere #orro!e at
the start o+ the -ro9ect"
I+ this !as one, a larger a$ount !oul have to #e #orro!e at the #eginning
o+ the -ro9ect, to cover the interest -ay$ents that !oul #e ue uring the
ter$ o+ the -ro9ect"
This situation !oul also increase total interest costs, as interest !oul nee
to #e -ai on the $oney that !as #orro!e to $eet the interest -ay$ents
the$selves"
/a-italising interest is also use uring the start<u- -hase o+ ne! #usiness
o-erations, such as !hen a #usiness o!ner -rovies a loan to the #usiness as
!ell as investing e&uity +uns"
4.2.2.5.!. Debt alulations
2inancial calculations are iscusse in etail in the section #eginning on -age
820"
So$e s-eci+ic e3a$-les relating to e#t calculations are liste #elo!"
4.2.2.5.!.1. 4nterest
Interest is calculate #y $ulti-lying the -rinci-al a$ount #y the interest rate"
The +ollo!ing +or$ula can #e use to calculate the interest that is ue +or a
-erio o+ ti$e
3)* 100
days of number rate erest int
principal erest int
In the case o+ $onthly interest, the nu$#er o+ $onths !ill give a close result
to the e3act +igure, rather than using actual ays"
330
2or e3a$-le, the interest -ay$ent ue on a #on !ith a +ace value o+ G*0, an
interest rate o+ 1L, an a si3<$onthly -ay$ent coul #e calculate using the
+ollo!ing e3a$-le
12
)
100
1
*0 erest int
2
4.2.2.5.!.2. 'mortising loan repa$ments
The re-ay$ents on an a$ortising loan can #e calculate using the +ollo!ing
+or$ula"
This +or$ula is a re<arrange$ent o+ the stanar annuity +or$ula +or the
-resent value o+ a series o+ regular cash +lo!s, !ith the -resent value set to
e&ual the loan a$ount"
( )
n
y
y
principal payment

+

1 1
In this +or$ula, the varia#les have the +ollo!ing $eaning
n The nu$#er o+ -erios" This is the nu$#er o+ years in
the loan $ulti-lie #y 12 i+ $onthly calculations are
$ae"
y The interest rate -er -erio, in eci$al +or$at" 2or
$onthly calculations, this is the annual -ercentage rate
ivie #y 1200"
-rinci-al The a$ount o+ the loan
The o-eration o+ raising one nu$#er to the -o!er o+ another nu$#er is
kno!n as e3-onentiation"
33*
This +unction $ay #e re-resente in the +or$ y
3
, availa#le on calculators that
inclue scienti+ic or +inancial +unctions"
Dithin co$-uter so+t!are such s-reasheet -rogra$s, the carat sy$#ol :N;
or so$e other sy$#ol or +unction $ay #e use to calculate the value o+ one
nu$#er raise to another nu$#er"
A ta#le o+ loan re-ay$ents +or various ter$s an interest rates is -resente in
a--eni3 %"
2or e3a$-le, !ith a loan o+ G100 over a +ive year -erio, !ith an annual
interest rate o+ 1L, the +ollo!ing calculation !oul a--ly"
)0 12 * n
00)))8 0
1200
1
. y
( )
)0
00)))8 0 1 1
00)))8 0
100

+

.
.
payment
( )
)0
00)))8 1 1
00)))8 0
100

.
.
)81168 0 1
00)))8 0
100
.
.

321103 0
00)))8 0
100
.
.

020288 0 100 .
03 2.
4.2.2.5.!.3. Embe((e( interest rates
In so$e cases, the -ay$ents !ill #e kno!n, ho!ever the interest rate $ay
not #e kno!n"
33)
2or e3a$-le, a -rouct $ay #e o++ere +or sale through a series o+
instal$ents"
The interest rate that is inclue !ithin the instal$ents $ay #e s-eci+ie in
the sale contract, ho!ever i+ this is not the case, then the interest rate can #e
eter$ine using the +ollo!ing a--roach"
2irst, the e&uivalent value as a single -ay$ent $ust #e kno!n"
This coul #e #ase on a se-arate -rice o++ere +or a single<-ay$ent
-urchase, or an esti$ate o+ the value #ase on the -rices o+ si$ilar ite$s"
The calculation uses the sa$e annuity +or$ula as #e+ore"
This is re<arrange into the +ollo!ing +or$
( )
0
1 1

+

principal
y
y
payment
n
This +or$ula cannot #e calculate irectly, an a trial<an<error a--roach, or
a co$-uter -rogra$ such as a s-reasheet, $ust #e use to eter$ine the
value o+ :y; that results in the e&uation #eing e&ual to @ero"
This is also kno!n as the :internal rate o+ return; o+ the series o+ cash +lo!s"
4.2.2.5.!.4. #in6ing fun(s
A :sinking +un; is a +un in !hich regular -ay$ents are -ut asie to reach a
s-eci+ic +igure on a +uture ate"
This a--roach is so$eti$es use to -ut asie +uns to -ay +or the
re-lace$ent o+ an ite$ o+ e&ui-$ent, +or e3a$-le"
In so$e cases a sinking +un $ay re-resent an actual #ank account or other
+un holing, ho!ever in $ost cases this is an accounting entry in the general
lia#ilities o+ the #usiness"
The -ay$ent re&uire +or a sinking +un can #e eter$ine using a stanar
+or$ula, !hich calculates the +uture value o+ a series o+ regular -ay$ents"
338
This +or$ula is usually kno!n as the +uture value o+ an annuity"
The +or$ula assu$es that each -ay$ent accu$ulates interest +ro$ the ti$e
that it is $ae"
2or e3a$-le, this a--roach !ill calculate the +inal #alance o+ a #ank account,
!here regular contri#utions are $ae into the account"
The +irst stage in this -rocess is to calculate the +uture value than nees to #e
accu$ulate"
This !oul o+ten #e an e3isting value, increase to allo! +or in+lation"
The +uture value o+ a single value on the current ate can #e calculate using
the +ollo!ing +or$ula"
n
rate erest int
amount value future

,
_

+
100
1
In this +or$ula, the +ollo!ing varia#les a--ly"
n The nu$#er o+ -erios, such as the nu$#er o+
years
interest rate The interest rate -er -erio, in -ercentage +or$at

2or e3a$-le, a $achine !ith a value o+ G100 $ay have a li+e s-an o+ +ive
years o+ o-eration"
A sinking +un $ay #e create to allocate +uns to re-lace the e&ui-$ent at
the en o+ the +ive year -erio"
Assu$ing an in+lation rate o+ 0L, the value at that ti$e coul #e calculate
using the e3a$-le #elo!"
331
*
100
0
1 100

,
_

+ value future
122
The -ay$ents coul then #e calculate using the +ollo!ing +or$ula
( ) 1 1 +

n
y
y
value future payment
In this +or$ula, the varia#les have the +ollo!ing $eaning"
y The interest rate -er -erio" This is the annual rate ivie
#y 1200, i+ $onthly calculations are use
n The nu$#er o+ -erios" This is the nu$#er o+ $onths, i+
$onthly calculations are use"
Assu$ing an interest rate o+ 1L, the +ollo!ing calculation !oul a--ly"

)0 12 * n
00)))8 0
1200
1
. y
( ) 1 00)))8 0 1
00)))8 0
122
)0
+

.
.
payment
)) 1.
4.2.2.5.7. Debt management
336
7e#t $anage$ent involves arranging loans an organising #on issues,
$anaging the #alance o+ +i3e an +loating interest rates, $anaging the
rollover o+ e#t an other e#t<relate issues"
4.2.2.5.7.1. /i)e( & floating interest rates
The interest rate on e#t is generally a +i3e rate +or the ter$ o+ the loan, or a
+loating rate that varies on a regular #asis"
Most #ons issue #y co$-anies are +i3e<rate e#t"
Bank loans can #e either +i3e<rate or +loating<rate"
2acilities !ith +loating #alances, such as overra+ts, generally also have
+loating interest rates"
2loating interest rates have the avantage o+ allo!ing the co$-any to
restructure the assets an e#ts o+ the #usiness as interest rates rise an +all"
This also avois the risk that the #usiness $ay #e locke into a long -erio o+
-ay$ents on +i3e<rate e#ts at high interest rates"
=o!ever, interest rates can #e highly volatile"
Short<ter$ s-ikes in interest rates occur !hen rates rise shar-ly +or a -erio
o+ several $onths, or in so$e cases several years"
This can lea to cash +lo! -ro#le$s +or the #usiness as large interest
-ay$ents are ue on +loating<rate e#t"
4.2.2.5.7.2. -anaging interest rate ris6
/or-orate treasuries use a nu$#er o+ $ethos to $anage interest rate risks"
This inclues $aintaining a $i3 o+ +i3e<rate an +loating rate e#t, !ith
#ons issue !ith various i++erent ter$s"
2utures contracts can #e use to lock in interest rates o+ lening or #orro!ing
on +uture ates, an can also #e trae to hege ca-ital gains or losses in e#t
-ort+olios"
300
Ather +inancial $arkets instru$ents, incluing o-tions an :s!a-s; are also
use"
A s!a- is a contract that involves one -arty e3changing a series o+ +i3e<rate
interest -ay$ents +or a series o+ +loating rate interest -ay$ents +ro$ the other
-arty"
The net i++erent in -ay$ents is e3change on each interest -ay$ent ate"
2or e3a$-le, a co$-any that issue a large a$ount o+ +ive<year +i3e<rate
#ons coul enter a s!a- transaction !ith another -arty, to -ay the +i3e
interest -ay$ents to the other -arty, an receive +loating interest -ay$ents in
return"
This !oul allo! the co$-any to issue +i3e<rate securities, an a9ust the
interest rate e3-osure to #e -artially e3-ose to +loating rates"
4.2.2.5.7.3. #mall enterprises
Interest rate risk $anage$ent !ithin s$aller enter-rises $ay involve
choosing #et!een +i3e<rate an +loating<rate loans"
2loating rate e#t e3-oses the #usiness to the risk o+ a shar- rise in interest
rates, an cash +lo! -ro#le$s ue to interest -ay$ents"
=o!ever, long ter$ +i3e rates $ay leave the #usiness locke into -aying
high rates +or an e3tene -erio o+ ti$e"
Dhen this occurs, a +i3e ter$ loan can so$eti$es #e cancelle #e+ore the
ter$ e3-ires"
=o!ever, this !oul lea to a ca-ital loss +or the #ank, !hich !oul loose
the +uture interest strea$, an a large ter$ination -enalty $ay a--ly,
calculate +ro$ the i++erence in interest rates over the -erio"
Alternatively, i+ interest rates rise, the #usiness !oul #ene+it +ro$ #eing
locke into a long ter$ loan at a lo! interest rate"
2i3e loan ter$s in the range o+ 3 to * years !oul avoi so$e o+ the
-ro#le$s !ith +loating<rate or long<ter$ +i3e<rate e#t"
Meiu$ ter$ rates are less volatile than +loating rates, an o not rise or +all
as $uch as +loating rates !hen rates $ove"
301
This $ay reuce the risk o+ a cash +lo! -ro#le$s evelo-ing over a short
-erio o+ very high interest rates"
Also, this !oul avoi the -ossi#ility o+ #eing locke into a +i3e rate +or a
long -erio o+ ti$e !hen the general level o+ interest rates ha +allen"
4.2.2.5.7.4. 'verage interest rates
The interest rate -ai on the #usinessCs e#t can have a signi+icant i$-act on
the -ro+ita#ility o+ a #usiness"
2or e3a$-le, a #usiness $ay #e largely e#t<+une, !ith returns +ro$
o-erations #eing 10L o+ assets, an e#t interest rates #eing 1L"
In this case, the net -ro+it !oul #e 2L o+ assets"
=o!ever, i+ the interest rate rose +ro$ 1L to 6L, the net -ro+it !oul +all #y
one<hal+ to 1L o+ assets"
The average interest rate is the average rate -ai across all the #usinessCs e#t
+acilities"
This can #e calculate using either o+ the +ollo!ing a--roachesE
principal total
loan each for ' rate erest int principal ' of sum
rate average

2or e3a$-le, i+ a #usiness ha a loan o+ G100 !ith an interest rate o+ 1L an

a loan o+ G*0 !ith an interest rate o+ 8L, the average interest rate coul #e
calculate using the +ollo!ing e3a$-le
*0 100
8 *0 1 100
+
+
rate average
.)8 8
302
This +or$ula is kno!n as a :!eighte average;"
This is !iely use in #usiness an +inance, an can #e use in any situation
!here the average o+ a set o+ nu$#ers nees to #e calculate, #ut each
nu$#er has a i++erent si@e or signi+icance !ithin the total"
Alternatively, the average rate coul #e calculate +ro$ the +ollo!ing
+or$ulaE
debt
ense exp erest int
rate average
This secon a--roach coul #e use to calculate the average interest rate
+ro$ a set o+ +inancial state$ents"
=o!ever, the result $ay not #e accurate i+ there !as a large change in the
e#t level uring the -erio"
Also, this a--roach can only #e use to calculate the historical average rate
on a -revious set o+ interest -ay$ents"
4.2.2.5.7.5. ,e(uing (ebt interest rates
The interest rate that is charge on a loan is co$-ose o+ t!o -arts"
The +irst -art is a #ase interest rate, !hich is the general level o+ interest rates
!ithin the econo$y"
The secon a$ount is kno!n as a :risk -re$iu$;, an is #ase on the risk
that a e+ault !ill occur an that the loan !ill not #e re-ai"
In so$e circu$stances, interest rates $ay #e reuce #y taking ste-s to
reuce the risk o+ the loan +ro$ the lenerCs -ers-ective"
These $ay inclueE
A++ering collateral, such as a -ro-erty +or a $ortgage"
Strengthening the +inancial -osition o+ the co$-any"
303
7evelo-ing a sta#le traing history o+ o-erations"
Also, in so$e cases i++erent leners $ay charge signi+icantly i++erent
interest rates"
In these cases it $ay #e !orth!hile s-ening ti$e locating the lener that
charges the lo!est rate o+ interest, as interest -ay$ents are o+ten a large
e3-ense +or a #usiness, an i++erences can #e signi+icant"
Hnlike -urchasing goos or services, or e-ositing +uns, there is no
i++erence to the #usiness in the source o+ the loan +uns, a-art +ro$ the
interest rate"
=o!ever, so$e leners charge higher interest rates ue to the +act that they
engage in higher<risk loans, such as unsecure loans"
In these cases, loans $ay #e re9ecte #y leners o++ering lo!er rates, #ut $ay
#e acce-te #y leners o-erating in a higher<risk -art o+ the loan $arket"
4.2.2.5.7.!. 8oan ,ollovers
,oan rollovers occur !hen the ter$ o+ a loan has e3-ire, an the -rinci-al is
ue +or re-ay$ent"
Business o-erates on a continuous #asis, an it is co$$on to roll<over a loan
+or a +urther -erio"
2or e3a$-le, a 3 year interest<only loan $ay #e taken out to +un the
e3-ansion o+ the #usiness"
At the en o+ the 3 years, the -rinci-al !oul #e ue +or re-ay$ent"
The #usiness $ay then !ish to re<ra! the loan on si$ilar ter$s +or another
3 years"
This !oul involve the #ank a9usting the interest rate to the current 3<year
+i3e rate, an interest -ay$ents !oul continue as #e+ore"
=o!ever, loan rollovers are at the iscretion o+ the #ank"
I+ the #usinessCs +inancial conition ha eteriorate, the #ank $ay re+use a
rollover re&uest, an re&uest re-ay$ent o+ the -rinci-al on the ue ate"
300
The risk o+ this -ro#le$ occurring can #e reuce #y arranging several
i++erent loans than e3-ire on i++erent ates"
This is kno!n as a :staggere rollover;"
In general it !oul not #e -ractical +or a #usiness to have its entire e#t level
e3-iring on a single ay"
2or e3a$-le, three se-arate three<year loans coul #e $aintaine, !ith one
loan e3-iring in each year"
This !oul reuce interest rate risk an also reuce rollover risk, !ith the
chance o+ large -ay$ents #eing re&uire"
In -ractice, $ost #usinesses have a $i3 or i++erent e#t +acilities, !ith
various ter$s, a$ounts an interest rates"
4.2.2.5.8. Ot.er (ebt issues
4.2.2.5.8.1. Debt ovenants
In the case o+ $eiu$ si@e an large #usinesses, it is co$$on to inclue
e#t covenants !ithin the loan agree$ent"
This $ay #e inclue in a -ros-ectus that is issue to the -u#lic, or a #ank
loan agree$ent"
A e#t covenant is a conition that the #usiness agrees to a#ie #y, as -art o+
the loan agree$ent"
So$e co$$on e#t covenants !oul inclue conitions such as the
+ollo!ingE
That the #usiness !ill not increase the e#t<to<e&uity ratio a#ove a
s-eci+ie li$it"
That the #usiness !ill $aintain a $ini$u$ level o+ li&ui assets"
Breaching a e#t covenant is a #reach o+ the contract o+ the loan, an is
e&uivalent to the #usiness +ailing to $ake a e#t -ay$ent !hen it is ue"
30*
In -ractice, e#t covenants are o+ten the +irst ite$ to #e #reache !hen a
#usiness enters a conition o+ +inancial istress, an this $ay trigger a #ank
to #eco$e involve in -lanning a +inancial restructure o+ the #usiness to
restore solvency"
A :negative -lege; is an agree$ent to not -er+or$ a certain action"
A co$$on negative -lege conition !oul #e that the #usiness oes not
o++er a s-eci+ie asset as security to any other lener, so that the asset !oul
#e availa#le +or the general istri#ution o+ +uns in the event o+ a li&uiation"
4.2.3. #ubor(inate( (ebt
In so$e #usiness structures, a $ain -arent co$-any $ay o!n several
su#siiary co$-anies"
%ach su#siiary co$-any !oul have a se-arate #usiness o-eration an
+inancial structure"
In these cases, is it co$$on +or one co$-any !ithin the cor-orate grou- to
su--ly a loan to another co$-any, to act as a #u++er o+ shareholerCs +uns"
This is o+ten one on the #asis o+ :su#orinate e#t;"
Su#orinate e#t is e#t that ranks #ehin other e#t in the event o+ an
insolvency"
Dhen a li&uiation occurs, orinary e#t is re-ai #e+ore su#orinate e#t"
This is one to avoi a situation !here e3ternal leners ecline to len to the
co$-any, #ecause the co$-any alreay ha e#t that $ay a#sor# so$e o+ the
assets i+ insolvency occurre"
4.2.3.1.1.1. 8imite( reourse (ebt
:li$ite recourse; e#t a--lies to e#t !here the lener has access to s-eci+ic
cash +lo!s or asset #acking, rather than the general ca-acities o+ the #usiness"
This ty-e o+ +inancing is so$eti$es use in $ining -ro9ects, +or e3a$-le"
30)
In these cases, li$ite recourse e#t is raise to +un a $ine evelo-$ent"
The lener then has access to the cash +lo!s +ro$ the $ine o-eration, to
service the interest costs an ca-ital re-ay$ents o+ the e#t"
The lener oes not have access to the general cash +lo! o+ the #usiness"
As a se-arate e3a$-le, a lease over an asset $ay e++ectively #e a li$ite
recourse arrange$ent"
In these circu$stances, in the case o+ a li&uiation o+ the #usiness, the asset
is sol, an i+ there are insu++icient +uns raise to re-ay the lease e#t, the
re$aining e#t is !ritten o++, an the lener $ay not have access to the
general istri#ution o+ assets"
,i$ite recourse e#t $ay reuce the cash +lo! rain on a co$-any uring
the start<u- -hase o+ a -ro9ect"
This arrange$ent $ay also increase the e#t ca-acity o+ the #usiness an
reuce risk, #y se-arating certain e#t +ro$ the co$-anyCs +inancial
resources an restricting the e#t e3-osure to s-eci+ic assets"
4.2.3.1.1.2. 8i9ui(ation
In the event o+ the li&uiation o+ a #usiness, all assets are sol"
Secure e#t is e#t that is secure against a s-eci+ic asset"
The sale o+ each secure asset is use to re-ay that -articular e#t"
I+ there are not enough +uns raise +ro$ the sale to re-ay the entire e#t,
then the re$aining un-ai e#t #eco$es -art o+ the general unsecure -ool
o+ e#t"
I+ the asset sale raises $ore than the a$ount o+ the e#t, then the e#t is
re-ai in +ull, an the re$aining a$ount is ae to the -ool o+ assets +or
general istri#ution"
A+ter this -rocess has #een co$-lete, the availa#le assets are istri#ute
a$ong the -ool o+ unsecure e#ts on a -ro<rata #asis"
2or e3a$-le, there $ay #e su++icient +uns raise +ro$ the asset sales to
re-ay 10L o+ each e#t that is outstaning"
308
I+ all e#ts are re-ai in +ull, then any +uns re$aining are istri#ute to the
shareholers, at a +i3e a$ount -er share"
4.2.3.1.2. T.e (ebt raising proess
Raising e#t is generally one through #ank loans, or #y issuing #ons to the
-u#lic"
In the case o+ -ersonal lening, loan a--lications are su#$itte to #anks +or
#ank loans"
In the case o+ #usiness loans, the -rocess !oul generally involve iscussions
#et!een a contact at a #ank an the #usiness"
This $ay then #e +ollo!e #y the #usiness su#$itting in+or$ation such as
recent accounts an traing in+or$ation, !ith the #ank then either acce-ting
or re9ecting the loan"
A si$ilar -rocess occurs !ith large cor-orate loans, although in this case an
e3tene -erio o+ ti$e $ay #e involve"
,arge loans $ay involve etaile contracts, incluing a range o+ e#t
convents an restrictions, such as re&uire$ents to $aintain the e#t<to<e&uity
ratio #elo! a certain li$it, or $ini$u$ re&uire$ents +or li&ui +uns"
In the case o+ #ons, a -ros-ectus is -re-are !ith a set o+ auite accounts
an a revie! o+ #usiness o-erations"
The -ros-ectus is then issue to the -u#lic"
2uns are then su#scri#e +or #ons #y investors"
In so$e cases, the #ons are liste +or traing on a stock e3change, an can
#e #ought an sol #e+ore the +un e3-ires"
Traing in #ons is not a li&ui activity on $any stock e3changes"
Dhile the value an outlook o+ shares $ay change aily, the value o+ #ons
only changes !hen a signi+icant change in interest rates occurs, or a
signi+icant risk o+ insolvency arises !ithin a co$-any"
301
2or these reasons, hols are o+ten hel +or e3tene -erios o+ ti$e rather
than #eing regularly trae, an traing o+ -hysical #ons $ay #e a s$all
-art o+ stock e3change turnover"
306
4.2.3.1.3. Debt terms
A$ortising loan A loan structure !here the -ay$ents are
higher than the interest level, leaing to the
-rinci-al reucing to @ero at the en o+ the
loan ter$" %&ui-$ent leasing an $ost
-ersonal lening is #ase on a$ortising
loan structures"
Bearer #on A #on in !hich the na$e o+ the #on
holer is not recore #y the co$-any, an
-hysical -ossession o+ the #on certi+icate
is use as -roo+ o+ o!nershi- o+ the #on"
Bill A short<ter$ loan issue #y a co$-any, an
usually traa#le !ith other investors
Bon A loan structure issue #y cor-orations an
govern$ents, !ith regular interest -ay$ents
an the -rinci-al re-ai at the en o+ the
loan ter$"
Borro!er A -arty !ho #orro!s $oney +ro$ another
-arty, an -ays interest in return, along !ith
re-ay$ent o+ the -rinci-al accoring to a
loan scheule"
/a-italise interest Interest that is ae to the loan #alance,
rather than #eing -ai at the current ti$e"
/ou-on An interest -ay$ent on a #on" The cou-on
rate is the interest rate, an a cou-on
-ay$ent is an interest -ay$ent" This ter$
a--eare !ith #ons in the istant -ast,
!hich ha -a-er cou-ons attache +or each
interest -ay$ent"
/reit Borro!e +uns"
/reit risk The risk o+ e+ault on a loan arrange$ent,
!here -art or all o+ the loan a$ount $ay
not #e recovere"
/reitor A -arty that the #usiness o!es $oney to"
This is generally a lener, such as a #ank or
the investors in a #on issue, ho!ever it
coul inclue -arties that the #usiness
o!e $oney to +or -roucts receive or
services -er+or$e"
7e#t covenant A conition inclue in a loan agree$ent or
-ros-ectus, such as a conition that the
#usiness !ill not allo! the e#t<to<e&uity
3*0
ratio to rise a#ove *0L"
7e#t issue The issue o+ a -ros-ectus an acce-ting
+uns as -art o+ an issue o+ #ons" The
-ros-ectus !oul s-eci+y the ter$s o+ the
#on, such as a 1L annual cou-on rate -ai
si3<$onthly, !ith -rinci-al re-ai at the en
o+ a +ive<year -erio" 7e#t issues are
usually +or a s-eci+ie $a3i$u$ a$ount o+
+uns"
7e#tor A -arty that o!es $oney to the #usiness"
7e#t<to<e&uity ratio The ratio o+ e#t to e&uity, use to asses the
level o+ e#t !ithin a #usiness"
7e+ault 2ailing to $ake a -ay$ent uner a loan
agree$ent on the ue ate" Dhen a e+ault
conition occurs, a creitor can take action
such as selling a secure asset, or +iling an
a--lication in a court to have the #usiness
li&uiate"
7iscount security A loan that is conucte !ith t!o cash
+lo!s, an initial in+lo!, an a re-ay$ent o+
the +ace value at $aturity" The +inal
-ay$ent is usually a roun +igure, !ith the
initial -ay$ent calculate as a iscount to
the +ace value, #ase on an interest rate an
the nu$#er o+ ays"
2ace value The a$ount o+ -rinci-al re-ay$ent ue at
the en o+ the loan ter$"
2inance ,ease A lease o+ an ite$ o+ e&ui-$ent, !here an
asset an lia#ility are recore on the
#alance sheet"
(earing The level o+ e#t co$-are to the level o+
e&uity invest$ent" This is co$$only
calculate using the -ercentage o+ e#t to
total assets" Alternatives inclue the e#t<
to<e&uity ratio, an a $ulti-le, such as
gearing o+ three ti$es, !ith three ollars
#orro!e +or each ollar investe"
Inscri#e stock A #on in !hich the na$e o+ the #on
holer is recore #y the co$-any, in
contrast to a :#earer #on;"
Interest 5ay$ent to a lener in e3change +or
#orro!ing +uns"
Interest rate The -ercentage use to calculate the interest
-ay$ent, co$-are to the loan a$ount"
,ease A loan use to #uy an ite$ o+ e&ui-$ent,
3*1
!ith the e&ui-$ent #eing use as security
+or the loan" This is kno!n as :o++<#alance<
sheet e#t;, as the loan itsel+ is generally
not recore on the #alance sheet, only the
interest -ay$ents are recore" This is a
si$ilar arranging to hiring e&ui-$ent, an
involves a regular -ay$ent, rather than
recoring an asset an a e#t on the #alance
sheet"
,ener A -arty that loans $oney to a #usiness in
return +or interest -ay$ents, an the
re-ay$ent o+ -rinci-al accoring to a
e+ine scheule" Also re+erre to as an
investor in the case o+ su#scri#ing to #on
issues"
,oan<to<valuation ratio A #anking ter$ that is e&uivalent to a
gearing ratio, this is the si@e o+ the loan as a
-ercentage o+ the collateral asset value"
Maturity The ate that a loan arrange$ent ter$inates"
4egative -lege A conition in a loan contract that s-eci+ies
that an action shoul not #e taken, such as
o++ering an asset to another lener as
security"
4ote A short<ter$ loan, o+ten issue #y a
govern$ent, an traa#le !ith other
investors"
A++<#alance<sheet e#t An arrange$ent that inclues e#t !ithin
the structure, an is not recore as se-arate
e#t an asset a$ounts on the #alance
sheet" %3a$-les inclue o-erating leases,
an so$e structures such as 9oint venture
arrange$ents"
A-erating ,ease A lease in !hich the lease -ay$ent is
recore as an e3-ense, an no recor is
$ae on the #alance sheet" This is si$ilar to
hiring e&ui-$ent on a short<ter$ #asis, or
renting a -ro-erty"
5ros-ectus A etaile ocu$ent that inclues a +ull set
o+ auite accounts, a revie! o+ the
#usiness, an s-eci+ies the interest an
-rinci-al -ay$ent ter$s" 5ros-ectuses are
use +or #oth e&uity an e#t raisings +ro$
the general -u#lic"
Risk -re$iu$ An a$ount ae to a #ase interest rate to
co$-ensate +or the risk o+ e+ault on a loan"
3*2
Rollover To continue a loan +or a +urther -erio at the
e3-iry o+ the initial loan" 2or e3a$-le, a 3<
year loan $ay #e continue +or another 3<
years at the ne! 3<year interest rate"
Se$i<annual Si3<$onthly" Most #ons are se$i<annual
an -ay interest t!ice a year"
Staggere rollover Rolling<over a large loan #alance in several
-arts on i++erent ates to reuce interest
rate risk an the risk o+ large out+lo!s i+
rollover re&uests are ecline"
Su#orinate e#t A loan that ranks #elo! other e#t in the
event o+ a li&uiation" This loan is usually
su--lie #y an associate co$-any"
Su#scri#e To co$-lete an a--lication +or$ in a
-ros-ectus an sen a che&ue, as -art o+ a
#on issue" This !oul result in the investor
receiving interest -ay$ents an -rinci-al
re-ay$ents in accorance !ith the ter$s o+
the e#t issue"
Ter$ The -erio o+ ti$e that the loan
arrange$ent o-erates +or"
3*3
4.2.3.2. E9uit$
%&uity is na$e that is given to the net +uns hel !ithin a #usiness"
This is e&ual to the total assets hel in the #usiness, less the e#ts that are
o!e"
The sa$e conce-ts an issues a--ly !hether a sole traer, -artnershi- or
co$-any structure is use"
=o!ever, the co$-any structure is the clearest structure, an the ter$s use
+or co$-anies are use+ul in illustrating the structure o+ e&uity"

4.2.3.2.1. #oures of e9uit$
%&uity can accu$ulate !ithin the #usiness ue to retaine -ro+its +ro$
-revious years"
Also, e&uity can #e contri#ute irectly #y shareholers"
This $ay #e aitional +uns trans+erre into the #usiness +ro$ the e3isting
shareholers, or it coul #e +uns raise +ro$ ne! investors"
In either case, the o!nershi- o+ the #usiness a+ter the e&uity raising is s-lit in
-ro-ortion to the a$ount o+ shares hel #y each investor"
In turn, this is e&ual to the a$ount o+ $oney investe in the #usiness, or the
nu$#er o+ shares -urchases +ro$ other -arties"
4.2.3.2.2. 7ses of e9uit$
Aitional e&uity is raise in so$e o+ the +ollo!ing circu$stancesE
To +un a -urchase o+ another #usiness"
To +un a $a9or e3-ansion or ca-ital e3-eniture -rogra$"
3*0
To sta#ilise the -osition o+ the co$-any i+ the co$-any enters a
conition o+ +inancial i++iculty, such as high e#t levels an loss<
$aking o-erations"
4.2.3.2.3. ,aising e9uit$
5u#lic co$-anies are large #usinesses !ith shares that are generally liste on
a stock e3change"
These shares are #ought an sol #y the general -u#lic"
Ather #usiness structures, incluing -rivate co$-anies, sole traers an
-artnershi-s, involve a s$all nu$#er o+ #usiness o!ners, generally having
-ersonal involve$ent in $anaging the #usiness"
Raising e&uity is istinctly i++erent in -u#lic co$-anies +ro$ -rivate
#usiness structures"
The regulations +or raising e#t an e&uity +ro$ the general -u#lic are
controlle #y the co$$ercial la!"
This s-eci+ies a etaile set o+ conitions an -roceures, !hich $ay inclue
the ty-e o+ in+or$ation that shoul #e inclue in a -ros-ectus, together !ith
the ti$ing o+ various stages in the -rocess"

4.2.3.2.3.1. 3ubli ompanies
In the case o+ -u#lic co$-anies, a -ros-ectus or -u#lic announce$ent is
issue, an investors su#scri#e cash in return +or ne!ly<issue shares"
This increases the cash holings !ithin the co$-any"
Raising e&uity in this situation has little e++ect on the control o+ the co$-any"
Both #e+ore an a+ter the e&uity raising, the shares are generally s-rea
across a large nu$#er o+ iniviual investors"
The a#ility o+ a liste co$-any to raise e&uity e-ens on the +inancial
conition o+ the #usiness, an the general econo$ic environ$ent"
3**
(enerally e&uity can #e raise unless the co$-any is at serious risk o+
insolvency in the short or $eiu$ ter$"
Raising e&uity to sta#ilise the +inancial conition o+ a co$-any that has high
e#t levels or is e3-eriencing -oor o-erating conitions is a co$$on
occurrence"
The ne!ly<issue shares $ay #e o++ere at a iscount to the current $arket
-rice, to attract interest +ro$ investors"
This ilutes the e3isting shareholings, unless the shareholer su#scri#es +or
the +ull set o+ rights that are allocate accoring to their nu$#er o+ shares"
The a#ility to raise e&uity is heavily e-enant on the current econo$ic
environ$ent"
Raising e&uity $ay #e i++icult or i$-ossi#le uring -erios o+ econo$ic
recession, or -erios o+ negative stock $arket returns"
At these ti$es, there $ay not #e su++icient interest +ro$ investors to #e a#le
to raise aitional +uns"
4.2.3.2.3.2. 3rivate business strutures
In the case o+ -rivate #usiness structures, a i++erent situation a--lies"
In these cases, either +uns $ust #e contri#ute +ro$ the e3isting #usiness
o!ners, or ne! investors $ust #e -ersonally locate"
In the secon case, the ne! investors !ill o!n a share o+ the #usiness in
-ro-ortion to the +uns that they have investe, an control o+ the #usiness
$ay #e eter$ine #y the co$#ine ecisions o+ the co$-lete grou- o+
#usiness o!ners"
Involving ne! -arties in the o!nershi- an control o+ the #usiness is a $a9or
ste-, an this is usually not one unless a $a9or change in the structure an
o-erations o+ the #usiness is intene"
%&uity invest$ent $ay so$eti$es #e availa#le +ro$ investors !ho !ish to
$ake a -assive +inancial invest$ent, rather than #eco$ing -art o+ the
o-eration o+ the #usiness itsel+"
3*)
This still involves giving u- -artial o!nershi- o+ the #usiness, ho!ever it
$ay result in the e3isting #usiness o!ners continuing to control the
$anage$ent an evelo-$ent o+ the #usiness"
This arrange$ent $ay #e -re+era#le to #ringing in ne! -artners to the
#usiness o-eration, as this ste- o+ten leas to the #reak<u- or closure o+ the
#usiness in the long ter$"
5assive invest$ent e&uity +uns $ay #e availa#le +ro$ iniviuals in so$e
cases"
This can #e source through avertise$ents inviting contact +ro$
-ro+essional investors, through #usiness #rokers, an through !or<o+<$outh
contact"
A #usiness cannot avertise to raise e&uity +ro$ the general -u#lic !ithout
converting the #usiness to a -u#lic co$-any an issuing a -ros-ectus"
This is an e3-ensive an co$-le3 -rocess that is usually only one once the
#usiness reaches a signi+icant si@e"
5rivate e&uity invest$ent $ay also #e source +ro$ :venture ca-ital; +uns"
'enture ca-ital +uns are +uns that s-ecialise in $aking irect e&uity
invest$ents in s$all an $eiu$ si@e #usinesses"
2or e3a$-le, this $ay involve a #usiness that !as alreay o-erating !ith
sta#le o-erations, #ut !as in a -osition to raise +uns to +un a $a9or
e3-ansion"
4.2.3.2.4. ,e(uing E9uit$
4.2.3.2.4.1. Divi(en(s
7iviens are istri#utions o+ the e&uity ca-ital to investors"
/o$-anies o+ten -ay iviens t!ice<yearly, !ith the ivien level set to
#e a -ro-ortion o+ the average -ro+it"
7i++erent #usinesses have i++erent ivien -olicies, ranging +ro$ no
iviens, to -aying out the +ull -ro+it as ivien -ay$ents"
3*8
In the $a9ority o+ cases, -art o+ the -ro+it is istri#ute as iviens, !hile
-art is retaine to +un re-lace$ent o+ +acilities an e3-ansion -rogra$s"
4.2.3.2.4.2. +apital (istributions
/a-ital istri#utions occur !hen a large a$ount o+ e&uity ca-ital is
istri#ute to shareholers"
This is si$ilar to a large ivien -ay$ent, ho!ever a ca-ital istri#ution
involves a signi+icant reuction in ca-ital, rather than -aying out recent
-ro+its"
This $ay #e one in circu$stances in !hich a large a$ount o+ e&uity ca-ital
has accu$ulate !ithin the co$-any"
This $ay arise in situations !here the co$-any has ha an e3tene -erio
o+ success+ul o-eration, an in situations such as !hen a $a9or #usiness unit
has #een sol"
4.2.3.2.4.3. Bu$ba6s
A #uy#ack o+ shares or an interest in a -artnershi- occurs as a $etho o+ an
investor !ithra!ing +ro$ the #usiness o-eration"
5u#lic co$-anies o+ten take this a--roach as a $etho o+ reucing e&uity
ca-ital, as an alternative to a ca-ital istri#ution"
In a #uy#ack, +uns +ro$ !ithin the #usiness are use to #uy the shares or
-artnershi- interest +ro$ the investor"
The shares are then cancelle"
This allo!s the investor to sell their shares, an the #usiness reuces in si@e
#y the a$ount o+ the !ithra!n invest$ent"
The -rocess has the e++ect o+ the shareholer !ithra!ing their share o+ the
#usiness value in the +or$ o+ cash"
This a--roach is use #y -rivate co$-anies +or t!o reasons"
3*1
2irst, in so$e cases another investor $ay not #e availa#le to #uy the shares
o+ the investor !ho !ishes to e3it"
A #uy#ack allo!s an investor to !ithra! their +uns an e3it the #usiness"
A secon reason is that the #usiness $ay !ish to reuce the si@e o+ the
o-eration, rather than have another investor take over the shares o+ the
-revious holer"
2or e3a$-le, in the case o+ a -artner !ithra!ing +ro$ a -artnershi-, the
re$aining -artners $ay !ish to reuce the si@e o+ the -artnershi-, rather than
having a ne! -artner co$e in"
4.2.3.2.5. T.e e9uit$ raising proess
Raising e&uity in a -rivate o-eration involves locating a -arty !ho !ishes to
invest in the #usiness"
Ance this is one, the investorCs +uns are trans+erre into the #usiness
accounts, an shares are issue or a -artnershi- interest is recognise"
Dhen a #usiness is +irst +loate, it is converte to a -u#lic co$-any"
This involves -re-aring a -ros-ectus, usually !ith the ai o+ an invest$ent
#ank or stock#roking +ir$, !ho $anages the +loat -rocess"
The -ros-ectus contains a +ull set o+ auite accounts, an a !ritten
escri-tion an revie! o+ the #usiness"
The -ros-ectus is then issue to the -u#lic, +uns +or shares are receive, an
so$e ti$e later the shares are liste +or traing on a stock e3change"
The original #usiness o!ners o+ten retain a large -ortion o+ the shares, an
sell the re$ainer through the +loat"
In the case o+ co$-anies that are alreay liste, raising e&uity is one #y a
:rights issue;"
This generally involves the e3isting shareholers #eing o++ere the right to
-urchase aitional shares, in -ro-ortion to their current shareholing"
In so$e cases, these rights are liste an can #e sol on the e3change, in
!hich case other investors can #uy the rights an su#scri#e +or the shares"
3*6
4.2.3.2.!. Ot.er e9uit$ issues
4.2.3.2.!.1. =egative e9uit$
A #usiness can have negative e&uity"
This occurs !hen the value o+ the e#t is greater than the value o+ the assets"
4egative e&uity oes not i$-ly that a #usiness is insolvent"
A #usiness can continue o-erating as long as it has su++icient cash to $ake
-ay$ents as they #eco$e ue"
A #usiness !ith negative e&uity $ay have -ositive cash +lo! or negative
cash +lo!"
=o!ever, negative e&uity generally i$-lies that the #usiness is in serious
+inancial trou#le"
This situation coul #e correcte #y raising aitional e&uity to restore the
#alance sheet"
Alternatively, an i$-rove$ent in traing conitions $ay see cash +lo! into
the #usiness an asset values rise, !hich coul return the #usiness to a sta#le
+inancial -osition"
4egative e&uity occurs !ith #usinesses e3-eriencing -oor o-erating
conitions, start<u- enter-rises !here large e3-enses are incurre, an in the
evelo-$ent -hase o+ -ro9ects"
4.2.3.2.!.2. Dilution
In cases !here ne! shares are issue at the sa$e value as the current $arket
-rice, the e&uity issue oes not irectly a++ect the value o+ the e3isting shares"
This ste- si$-ly results in the co$-any #eco$ing a larger enter-rise"
The original shares !ill have the sa$e value, although they !oul re-resent a
s$aller -ro-ortion o+ the e3-ane co$-any"
3)0
=o!ever, a share issue conucte in this !ay $ay attract little interest, as
shares coul alreay #e #ought through the stock e3change at the current
-rice, regarless o+ the e&uity issue"
2or this reason, e&uity issues are generally -rice at a s$all iscount to the
current $arket value, to attract investor interest"
This -rocess results in a reuction in the value o+ the e3isting shares, an a
trans+er +ro$ the -revious shares to the ne!ly<issue shares"
This e++ect is kno!n as :ilution;"
7ilution can #e avoie i+ the shareholer su#scri#es +or the +ull set o+ ne!
shares that is relate to their current shareholing, or sells the rights through
the stock e3change"
In cases !here the share -rice is traing at the sa$e level as the net assets -er
share, an the share issue is not conucte at a iscount, the net assets -er
share o+ the original shares o not change +ollo!ing the issue"
=o!ever, in the case o+ a share -rice that is traing a#ove the net assets -er
share, a share issue !oul increase the net asset #acking +or each share"
This is #alance against the +act that the ne!ly<raise e&uity is generally in
the +or$ o+ cash, an $ay not result in an increase in o-erating inco$e in the
short ter$"
An #alance the shares $ay rise or +all +ollo!ing an e&uity issue, e-ening
on the -lans an structure o+ the ne! o-eration, although the raising o+ e&uity
is a -ro<active ste- an $ay lea to an i$-rove outlook +or the #usiness"
4.2.4. +apital ,eonstrutions
A ca-ital reconstruction occurs !hen a change is $ae in the !ay that the
shares are arrange !ithin the co$-anyCs ca-ital #ase"
This $ay occur in con9unction !ith an e&uity raising or ca-ital istri#ution,
or it $ay si$-ly involve a change in the nu$#er o+ shares"
A share s-lit is a co$$on +or$ o+ ca-ital reconstruction"
In a 1 +or 10 share s-it, +or e3a$-le, each share is s-lit into 10 ne! shares"
3)1
%ach o+ the ne! shares !oul then #e !orth one<tenth o+ the value o+ the ol
shares"
Share s-lits an share consoliations o not have any a++ect on the co$-any,
or on the value o+ the share holings"
=o!ever, ca-ital reconstructions o+ this ty-e are one +or several reasons"
2ro$ a -ractical -ers-ective, each iniviual share nees to #e -rice !ithin
a certain -rice range"
I+ a single share has a large value, then investors !ishing to -urchase a s$all
value shareholing, or to sell a s$all -art o+ their holing, !oul not #e a#le
to o so"
I+ the share -rice is too lo!, a ga- o+ a single cent $ay #eco$e a signi+icant
9u$- #et!een the -rice o+ a #i an the -rice o+ an o++er"
In -ractice, $ost share -rices are #et!een 20 cents an 20 ollars -er share"
A -ractical $ini$u$ shareholing, allo!ing +or $ini$u$ #rokerage costs,
!oul #e in the region o+ a +e! thousan ollars"
Dhen the share -rice $oves +ar outsie this -rice range, co$-anies !ill o+ten
arrange a share s-lit or a share consoliation to reset the share -rice to !ithin
a -ractical range"
Ane school o+ thought hols that traing volu$e in a co$-anyCs shares !ill
increase !hen a large nu$#er o+ lo!er<value shares are use, ho!ever a
nu$#er o+ statistical stuies have +aile to +in any evience o+ this e++ect"
The -rice o+ a single share is an irrelevant +igure as +ar as value is concerne"
2or e3a$-le, a holing o+ 10 shares !orth G* each has the sa$e value as a
holing o+ 2 shares !orth G2* each"
The +act than one share -rice is G* an the other is G2* oes not allo! any
co$-arison to #e $ae #et!een the t!o"
2or e3a$-le, t!o co$-anies coul #e ientical, #ut i+ one co$-any ha a
total o+ 100 shares on issue !hile the other ha 200 shares, then the -rice o+
the secon co$-anyCs shares !oul #e hal+ the -rice o+ the +irst co$-anyCs
shares"
3)2
=o!ever, high share -rices are usually the result o+ a long -erio o+ gro!th,
an on average a share !orth )*c is o+ten associate !ith a s$all co$-any or
a co$-any that has e3-erience a large +all in its share -rice, !hile a share
-rice o+ G00 !oul $ore o+ten #e associate !ith a large #lue<chi- co$-any
!ith a secure #alance sheet an sta#le o-erations"
:#onus shares; are aitional shares that are issue !ithout charge to e3isting
shareholers"
This is occasionally one +ollo!ing a -erio o+ success+ul o-eration, or in
-lace o+ a cash ivien"
=o!ever, a #onus share has no e++ect on the value o+ the shareholing"
2or e3a$-le, a shareholer $ay have 6 shares !orth G10, +or a total
shareholing o+ G60"
2ollo!ing a 1 +or 6 #onus issue, the share -rice !oul +all to G6 to re+lect the
larger nu$#er o+ shares, an the shareholer !oul have 10 shares !orth G6
each"
The total value o+ the shareholing re$ains unchange in these
circu$stances"
Bonus issues can #e use as a no$inal re+lection o+ a -erio o+ success+ul
o-eration"
3)3
4.2.4.1.1. E9uit$ terms
Buy#ack The co$-any #uying its o!n shares an then
cancelling the$" This can #e an on<$arket
#uy#ack, !hen shares are #ought through a stock
e3change, or an o++<$arket #uy#ack, !here
shareholers are contacte irectly" This is use to
reuce e&uity ca-ital, as an alternative to a ca-ital
istri#ution or ivien"
/a-ital istri#ution A istri#ution o+ e&uity +uns +ro$ the co$-any to
shareholers, at a certain a$ount -er share"
/a-ital
reconstruction
A change in the structure o+ e3isting shares, such
as a share s-lit that changes each e3isting share
into t!o ne! shares" This is so$eti$es co$#ine
!ith an e&uity raising or ca-ital istri#ution"
/or-orate action A transaction involving a ivien, rights issue,
share s-lit, or other event a++ecting a shareholing"
7ilution The e++ect that an e3isting shareholerCs value is
reuce i+ ne! shares are issue at a iscount to
the current $arket -rice"
7ivien A -ay$ent o+ e&uity ca-ital to shareholers"
(enerally $ae t!ice<yearly, an set to an a$ount
that is a -ro-ortion o+ the average -ro+it level"
2loat To convert a co$-any to a -u#lic co$-any #y
issuing a -ros-ectus, an selling a large section o+
the shares to the general -u#lic" The shares are
generally liste +or traing on a stock e3change a
short ti$e a+ter the su#scri-tion -erio has close"
,iste co$-any A co$-any in !hich the shares can #e #ought an
sol through a stock e3change" Anly -u#lic
co$-anies can #e liste"
4on<renounca#le
rights issue
A rights issue !here the rights cannot #e trae"
The shareholer $ust either su#scri#e +or the ne!
shares, or the rights la-se"
5artnershi- interest A share in a -artnershi-" 5artnershi- interests are
not traa#le as iniviual units in the !ay that
co$-any shares are" =o!ever, a ne! -artner can
#uy the -artnershi- interest +ro$ a -artner !ho is
!ithra!ing, an re-lace the -revious -artner in
the -artnershi-"
5rivate co$-any A co$-any that is not a -u#lic co$-any" A
co$-any $ust have a $ini$u$ o+ one irector
an one shareholer (!ho $ay #e the sa$e
3)0
-erson)"
5ros-ectus A etaile ocu$ent containing a +ull set o+
accounts an a !ritten revie! o+ the #usiness" A
-ros-ectus is re&uire #e+ore a co$-any can #e
+loate, or #e+ore an issue o+ #ons to the -u#lic
can #e $ae"
5u#lic co$-any A co$-any that $eets certain #asic $ini$u$
re&uire$ents, such as a $ini$u$ o+ +ive
shareholers"
Most large -u#lic co$-anies are liste, !ith their
shares trae on a stock e3change"
Renounca#le rights
issue
A rights issue !here the investor can sell the right
to su#scri#e +or a ne! share, usually +or a s$all
a$ount e&uivalent to the iscount, through the
stock e3change" Another investor can then
-urchase the right an su#scri#e +or the shares"
Rights issue A $etho o+ raising aitional +uns +ro$
shareholers" %ach shareholer is o++ere the right
to su#scri#e +or a nu$#er o+ ne! shares, in
-ro-ortion to their current shareholing"
Share A!nershi- o+ -art o+ a co$-any" The o!nershi-
o+ co$-anies is generally #roken u- into a large
nu$#er o+ shares" %ach share is entitle to one
vote at a co$-any $eeting such as the annual
general $eeting, receives iviens !hen
iviens are -ai, an generally rises or +alls in
value e-ening on the o-erating conitions o+ the
co$-any an general econo$ic conitions"
%ach share corres-ons to one share o+ the assets
o+ the co$-any, !hich a--lies in the case o+ a
li&uiation or takeover"
Share consoliation A co$-any action that results in e3isting shares
#eing $erge into a s$aller nu$#er o+ ne! shares"
This is one !hen the share -rice has sta#ilise at
a lo! level, ho!ever the +uture outlook is -ositive"
This oes not usually occur !hen share -rices are
lo!, unless the co$-any has a consiera#ly
i$-rove outlook"
Share S-lit S-litting e3isting shares into a larger nu$#er o+
ne! shares" The share -rice +alls to the level that
results in the total value o+ the shareholing, an
the total $arket ca-italisation, re$aining
unchange" This is so$eti$es one !hen a share
-rices rises a#ove the usual traing -rice range +or
co$-any shares"
3)*
Shareholer A -arty !ho o!ns a share in a co$-any"
Su#scri#e To co$-lete an a--lication +or$ in a -ros-ectus,
sen the a--lication +or$ an a che&ue, an
receive shares in the co$-any" This also a--lies to
su#scri#ing +or #on issues"
'enture ca-ital Invest$ent +uns that s-ecialise in $aking irect
e&uity invest$ents in s$all an $eiu$ si@e
-rivate #usinesses"
3))
4.2.4.2. 'ssets
4.2.4.2.1. T$pes of assets
Businesses hol assets o+ various ty-es"
2or e3a$-le, in #anking the assets are loans ue +ro$ custo$ers, !hile in
insurance the assets $ay #e +uns hel an investe to $eet insurance
clai$s"
=o!ever, in general #usiness activity, the assets o+ a #usiness usually +all
into three $a9or categories"
These areE
5ro-erty, -lant an e&ui-$ent 5hysical ite$s incluing lan an
#uilings, $anu+acturing -lants,
e&ui-$ent, vehicles an so on"
Intangi#le assets Bran na$es, ne!s-a-er $astheas,
#roacasting licenses, -atents, etc"
/ash . li&ui assets Reserves o+ cash on e-osit, traa#le
securities, #ons, an other assets to
su--ort +uning an #usiness o-eration"
4.2.4.2.2. -anaging assets
4.2.4.2.2.1. /inanial 'ssets
In the case o+ #anking, $anaging the assets involves creit assess$ent o+
loans an ensuring that loans !ith a -oor creit outlook are not acce-te, an
that loans !ith a +avoura#le creit outlook are not re9ecte"
Dithin insurance, as another e3a$-le, $anaging the assets $ay involve
+uns $anage$ent issues incluing allocating +uns across +i3e interest,
shares an -ro-erty invest$ents, $anaging the ter$ an structure o+ e#t
-ort+olios, risk $anage$ent an so on"
3)8
Managing lia#ilities !ithin insurance involves the uner!riting -rocess o+
assessing risks, eter$ining -re$iu$s, an acce-ting or re9ecting
a--lications"
4.2.4.2.2.2. 3.$sial assets
Managing -hysical assets involves organising insurance an $aintenance,
#uying an selling assets, re-lacing e3-ire assets, an ensuring that the
a--ro-riate $i3 o+ assets is hel"
Insurance can #e arrange +or -hysical assets in various !ays"
,arge ite$s $ay #e insure uner general insurance contracts"
In the case o+ $anu+acturing +acilities an s-ecialist e&ui-$ent, in so$e
cases a s-eci+ic insurance -olicy can #e arrange +or the +acility itsel+"
In so$e cases, ite$s o+ s$aller value are not insure"
This is e++ectively a :sel+<insurance; arrange$ent, !ith the co$-any #earing
the risk o+ e&ui-$ent #eing lost, stolen or estroye #y accient"
/ontract service arrange$ents +or the su--ly o+ ite$s such as co$-uter
e&ui-$ent $ay involve a nu$#er o+ i++erent a--roaches"
Iniviual ite$s $ay #e lease #y the #usiness, an overall +ee $ay #e
charge +or the !hole set o+ e&ui-$ent, or the #usiness $ay -urchase the
e&ui-$ent, !ith su--ort -rovie on a +ee<+or<service #asis"
Maintenance o+ e&ui-$ent can #e -er+or$e #y in<house o-erations, uner a
$aintenance service contract !ith an e3ternal -arty, or on an a<hoc #asis
using e3ternal services"
4.2.4.2.2.3. 4ntangible assets
Intangi#le assets inclue -atents, licences, $eia $astheas an #ran
na$es"
Bran na$es $ay nee a regular -ro$otion an avertising e3-ense to
$aintain the value o+ the #ran na$e"
3)1
Raising a #ran na$e to a -u#lic -ro+ile that results in value a--earing +or
the #ran na$e itsel+ $ay re&uire consiera#le ti$e an e3-ense in
avertising an -ro$otion"
Ane school o+ thought hols that a -ro+ile -osition can #e $aintaine over
the long ter$ !ith regular -ro$otion, ho!ever once the #ran na$e has
+allen +ro$ -u#lic vie!, it cannot #e resurrecte"
4.2.4.2.3. ,eplaing assets
So$e #usinesses retain their -hysical assets +or long a+ter their e++icient
!orking li+e has e3-ire"
This $ay #e one to avoi -aying the cost o+ re-lacing the e&ui-$ent"
Also, this $ay involve an atte$-t to e3tract every last ro- o+ use+ul value
+ro$ an ite$ o+ e&ui-$ent"
=o!ever, this a--roach can #e a +alse econo$y"
Autate e&ui-$ent $ay have a lo! -rouction rate, use $any ra!
$aterials, have a high error rate, re&uire e3cessive $aintenance an have a
high +re&uency o+ o!n<ti$e"
Also, technology avances as ti$e $oves #y, an $ore recent $achines $ay
#e $ore e++icient than an e&uivalent version o+ oler technology"
%&ui-$ent an +acilities o not nee to #e ke-t until they literally +all a-art,
an in $any cases a #etter result is achieve #y scra--ing e&ui-$ent !hen
its -er+or$ance #egins to eteriorate signi+icantly, an investing in ne!
$achinery an +acilities"
Dhile this $ay re&uire +uning through e#t or e&uity, an a large
e-reciation e3-ense $ay #e generate #y the ne! +acilities, this $ay also
lea to a large increase in -rouction e++iciency an -rouction ca-acity"
4.2.4.2.4. /un(ing replaement assets
Re-lace$ent assets can #e +une in a nu$#er o+ !ays"
3)6
In the case o+ s$aller ite$s, this $ay co$e +ro$ the general availa#le ca-ital
hel !ithin the #usiness"
In large re-lace$ent -rogra$s, e#t or e&uity $ay #e raise s-eci+ically +or a
ca-ital e3-eniture -rogra$"
%&ui-$ent that is lease can #e re-lace !ithout any +uning re&uire$ents"
Another a--roach is to raise a loan s-eci+ically +or an e&ui-$ent -urchase,
!ith the loan secure against the ite$ o+ e&ui-$ent"
In so$e cases, re-lace$ent assets are +une using a :sinking +un;"
A sinking +un is a +un that is allocate !hen the asset is +irst -urchase"
Money is set asie each year, an e-osite into the sinking +un"
At the en o+ the use+ul li+e o+ the e&ui-$ent, the sinking +un shoul hol
su++icient assets to ena#le a re-lace$ent ite$ o+ e&ui-$ent to #e -urchase"
The sinking +un $ay #e a -hysical #ank account or another ty-e o+ asset,
although usually this is 9ust an accounting entry in the general lia#ilities o+
the #usiness"
4.2.4.2.5. Ba6up failities
Assets $ay cease to #e availa#le ue to +aulty e&ui-$ent, +ire a$age, or +or
various other reasons"
Backu- +acilities involve +acilities -ut in -lace to ena#le -rouction to
continue i+ a $a9or asset is unavaila#le"
:reunancy; is one a--roach to this"
Reunant assets involve $aintaining t!o or $ore +acilities that -er+or$ the
sa$e +unction"
2or e3a$-le, a $anu+acturing +acility coul #e evelo-e in t!o halves, !ith
each hal+ o+ the +acility #eing a $irror i$age o+ the other"
A #reak<o!n in one section !oul then allo! -rouction to continue,
although at a reuce rate"
380
This a--roach e3ists in $any -hysical syste$s, ranging +ro$ the esigns o+
aircra+t to the structure o+ so$e #iological syste$s"
/ross<connections $ay also allo! one -art o+ a +acility to #e use to service
#oth +acilities +or a short -erio o+ ti$e, in the event o+ an e&ui-$ent +ailure"
,ess ra$atic e3a$-les o+ #acku- +acilities inclue #ack<u- generators to
su--ly electricity, an co$-uter ata #acku-s to allo! co$-uter o-eration to
#e restore in the event o+ a har!are +ailure"
4.2.4.3. Balane s.eet vs. Off*balane*s.eet assets
%&ui-$ent an +acilities can o+ten #e hel in t!o i++erent !ays"
Balance sheet assets involve #uying the e&ui-$ent or +acilities"
This $ay #e +une through e&uity or e#t"
A++<#alance<sheet assets involve leasing e&ui-$ent an #uilings"
The use o+ #alance sheet assets leas to an asset<#ase #usiness structure,
!hile the use o+ o++<#alance<sheet assets leas to a cash +lo! #ase #usiness
structure"
A cash +lo! #ase structure is generally a $ore +le3i#le structure than an
asset<#ase structure, an allo!s the #usiness to aa-t $ore easily to
change circu$stances"
There are various issues involve in the choice as to !hich $etho to use +or
-articular assets, an !hich $etho to use in general +or the #usiness activity
4.2.4.3.1. ,aising fun(s
Balance sheet assets re&uire raising +uns, either e&uity +uns +ro$ investors,
or e#t +uns +ro$ leners"
In so$e circu$stances, -articularly !ith -u#lic co$-anies, this $ay not
-resent any great i++icultly"
381
=o!ever, in other cases +uning $ay not #e availa#le, or +uning $ay #e
-ossi#le, #ut the #usiness o!ners $ay not !ish to increase e#t levels or
raise aitional e&uity"
Also, the +un raising -rocess can involve consiera#le ti$e an cost"
Hsing o++<#alance<sheet assets oes not re&uire +uning"
4.2.4.3.2. /le)ibilit$
The +le3i#ility o+ the various arrange$ents $ay vary consiera#ly"
Selling assets can #e a slo! an e3-ensive e3ercise"
In contrast, leasing -ro-erty $ay allo! a #usiness to $ove to another
#uiling !ith little e3-ense or i++iculty"
In the case o+ a large organisation, relocating #uilings $ay #e a $a9or
e3ercise that $ay involve a co$-lete re<!riting o+ tele-hone an co$-uter
ata services, installing esk s-ace an +acilities, an so on"
The -rocess can take a +ull year"
=o!ever, this -rocess nees to #e one !hether the #uiling is o!ne or
lease"
Selling an e3isting #uiling an -urchasing another #uiling $ay a an
even longer ti$e elay to the o-tion o+ changing -re$ises"
In the case o+ s$aller organisations, $oving +ro$ one lease #uiling to
another $ay #e -ossi#le in a relatively short -erio o+ ti$e"
An e3ce-tion to this $ay occur !hen a long lease is in -lace, an an
alternative tenant cannot #e +oun"
=o!ever, in general a change +ro$ one lease #uiling to another is +ar
si$-ler an chea-er than selling one -ro-erty an #uying another"
4.2.4.3.3. +as. flo5
,ease -ay$ents are a +i3e cash +lo!"
382
In the case o+ e#t<+une #alance sheet assets, the interest -ay$ents are also
a +i3e e3-ense"
=o!ever, !ith e&uity +une assets, there are no cash +lo!s re&uire to $eet
interest or lease -ay$ents"
This $ay reuce the risk o+ negative cash +lo! an insolvency -ro#le$s
cause #y the +i3e costs o+ e#t<+une or o++<#alance<sheet assets"
2or e3a$-le, i+ a #usiness o!ne a #uiling an ha little e#t, then it coul
survive a -erio o+ ti$e !ith very little inco$e !ithout #eco$ing insolvent"
=o!ever, in the case o+ leasing or e#t, the regular -ay$ents !oul have to
#e $aintaine regarless o+ the level o+ sales"
Strictly s-eaking, there is no +inancial i++erence #et!een the t!o
a--roaches, as the interest or lease -ay$ents !oul #alance the inco$e that
coul #e generate i+ the e&uivalent level o+ e&uity !as investe else!here"
=o!ever, +ro$ a -ractical cash +lo! -ers-ective, a #usiness that o!ne $ost
o+ its assets an ha little e#t !oul #e in a $ore secure -osition to
!ithstan a -erio o+ lo! inco$e than a #usiness !ith high +i3e costs"
4.2.4.3.4. 'sset values
Balance sheet assets nee to #e e-reciate, an assets $ay have to #e re<
value +ro$ ti$e<to<ti$e"
This leas to a $ore co$-le3 +inancial structure than a leasing arrange$ent,
!here iniviual -ay$ents are $ae +or the lease as ti$e goes #y"
Hner a lease arrange$ent, a single e3-ense is involve"
In contrast, a e#t<+une -urchase !oul involve a #alance<sheet e#t an
asset, interest costs, e-reciation, asset re<valuations an so on"
383
4.2.4.3.5. Off*balane*s.eet (ebt
,easing e&ui-$ent an other arrange$ents can #e use as a source o+ e#t
that is not inclue !ithin the structure o+ the co$-any, or recore on the
#alance sheet"
These ite$s are recore in the accounts as an e3-ense, rather than as
-ro-erty o!ne #y the #usiness"
A++<#alance<sheet e#t is use to avoi #reaching e#t covenants, to raise
e#t !hen other a--roaches are not availa#le, to avoi a++ecting the structure
o+ the #alance sheet, an to -ackage transactions in a convenient !ay"
A++<#alance<sheet e#t $ay o+ten #e :li$ite recourse; e#t"
This $eans that the e#t is only secure #y the asset itsel+, an the #alance
sheet is not e3-ose to the risk that !oul #e incurre i+ stanar e#t !as
raise"
A++<#alance<sheet e#t has several avantages +or the #usiness, an !here
this ty-e o+ transaction is availa#le, this $ay #e a use+ul #ene+it in the
+inancial $anage$ent o+ the #usiness"
,easing $ay have t!o i++erent characteristics"
An :o-erating lease; is si$ilar to hiring e&ui-$ent"
This is si$-ly a rental -ay$ent $ae in e3change +or using e&ui-$ent +or a
-erio o+ ti$e"
This ty-e o+ arrange$ent is use +or leasing -ro-erties, so$e e&ui-$ent
leases, an +or short<ter$ hiring o+ +acilities"
A :+inance lease; is si$ilar to a -ackage loan an -urchase arrange$ent"
In this case, the e&ui-$ent is lease, !ith the transaction #eing si$ilar to
raising e#t an then -urchasing the asset"
In the case o+ a +inance lease, an asset an a e#t are liste in the #alance
sheet"
Accounting stanars vary in the treat$ent o+ leases an other o++<#alance<
sheet e#t"
380
In the -ractical sense, a lease is an o-erating lease unless the #usiness is
a++ecte #y changes in the value o+ the asset"
This is usually not the case"
The i++erence #et!een an o-erating lease an a +inance lease is not clear<
cut, an the ecision as to ho! to account +or a lease $ay e-en on issues
such as !ho $aintaine the e&ui-$ent, !hich -arty !as e3-ose to rises or
+alls in the asset value, the arrange$ents at the en o+ the lease, an so on"
So$e leases are treate as +inance leases, !ith an asset an a e#t #eing
-lace on the #alance sheet, rather than a si$-le e3-ense #eing recore"
4.2.4.4. +apital management transations
4.2.4.4.1. #ale*an(*8easeba6
A sale<an<lease#ack is a ca-ital $anage$ent transaction that involves
selling the #usiness -re$ises, an re$aining !ithin the #uiling as a tenant"
This transaction $ay have several #ene+its"
A sale an lease#ack can #e use to raise +uns in the case o+ the #usiness
striking +inancial i++iculty, !ithout the -ro#le$s associate !ith relocating
to another -re$ises"
This is -articularly relevant i+ there are s-ecialist +acilities !ithin the
o-eration, such as vaults !ithin #ank #ranches"
A sale an lease#ack +rees u- the ca-ital in the #alance sheet, an allo!s the
-hysical -re$ises to #e $anage $ore e++ectively, !ith the a#ility to reuce
or increase the nu$#er o+ #usiness -re$ises !ithout great i++iculty"
So$e very large sale<an<lease#ack transactions have #een conucte, in
so$e cases involving nation!ie organisations !ith a large nu$#er o+
iniviual -ro-erties"
These -ro-erties can #e sol as a single -arcel into a -ro-erty invest$ent
trust, or sol iniviually to investors"
The -rice that is receive +or a sale o+ a -ro-erty in this !ay $ay #e strong,
as the #uiling is usually sol !ith a long<ter$ tenancy agree$ent"
38*
4.2.4.4.2. ,etiring (ebt
In the case o+ -ersonal lening, $ost loans are a$ortising an reuce in value
through the ter$ o+ the loan"
=o!ever, in the case o+ #usiness e#t, interest -ay$ents an ca-ital changes
are generally s-lit into t!o se-arate issues"
7e#t is +re&uently rolle<over +or a ne! -erio at the -revious level, an
reuctions in e#t are usually #ase on a s-eci+ic ecision to reuce the
a$ount o+ e#t hel #y the #usiness"
In cases !here the cash +lo! +ro$ o-erations is strong, the cash +lo! $ay
-rovie an o--ortunity to reuce the e#t level"
Strong cash +lo! +ro$ o-erations -rovies several $ain o--ortunities"
These inclueE
Retiring e#t"
Builing u- the e&uity +uns to strengthen the ca-ital #ase, or to
-re-are +or a $a9or transaction such as #uying another #usiness,
+uning a ne! start<u- o-eration, or +uning a $a9or ca-ital
e3-eniture -rogra$"
Arranging a ca-ital istri#ution to shareholers"
4.2.4.4.3. +apital (istributions
A co$-any $ay hol e3cess ca-ital +ollo!ing an e3tene -erio o+ strong
cash +lo!s, or +ollo!ing the sale o+ a $a9or asset or a $a9or -art o+ the
#usiness"
This can also occur ue to #uoyant econo$ic conitions, a success+ul
-rouct, or the inco$e -hase o+ a -ro9ect +ollo!ing a long an e3-ensive
evelo-$ent -rocess"
Dhen e3cess ca-ital accu$ulates !ithin the #usiness, various ste-s can #e
taken"
38)
In so$e cases, the ca-ital is si$-ly retaine !ithin the #usiness structure,
such as a co$-any structure"
=o!ever, this $ay lea to lo! return<on<ca-ital +igures, ue to the +act that
the e3cess ca-ital is not necessary to su--ort the #usiness o-erations"
Dhen an e3cess ca-ital situation arises, this o+ten -ro$-ts a search +or a
suita#le invest$ent or -ro9ect to use the +uns"
%3-aning the #usiness an evelo-ing ne! $arkets is a natural -art o+
#usiness o-eration, an this is a co$$on res-onse in these circu$stances
The #usiness o!ners shoul generally #e a!are o+ o--ortunities as they arise"
=o!ever, the act o+ actually seeking an invest$ent o--ortunity o+ten leas to
a -oor invest$ent ecision #eing $ae"
This $ay involve #uying another #usiness at an e3cessive -rice, #uying a
#usiness +or integration that is not really suita#le to #e integrate !ith the
e3isting o-eration, or -urchasing a #usiness +or invest$ent the leas to losses
or a lo! long ter$ return"
In these cases, a ne! irection is chosen that is o+ten not an e++ective
irection +or the #usiness, an is si$-ly chosen #ecause a #etter alternative
coul not #e +oun"
This can ruin an other!ise success+ul #usiness, as ne! o-erations are
integrate !ith e3isting o-erations, -erios o+ lo! -ro+ita#ility or negative
cash +lo! occur, an the general conition o+ the #usiness eteriorates"
In these circu$stances, a ca-ital istri#ution to the #usiness o!ners $ay
o+ten #e a #etter alternative"
This !oul #e a ecision $ae #y the #usiness o!ners in the case o+ a s$all
or $eiu$ si@e enter-rise, !hile it !oul #e a ecision o+ the $anage$ent
tea$ an the #oar o+ irectors in the case o+ a large -u#lic co$-any"
A ca-ital istri#ution reuces the ca-ital !ithin the #usiness to the level
re&uire to su--ort the #usiness o-erations, incluing nor$al e3-ansion an
invest$ent activities, an allo!s an e++icient o-eration to continue"
Announcing a ca-ital istri#ution to shareholers an a reuction in ca-ital is
a sign o+ goo +inancial $anage$ent #y the o-erators o+ a #usiness"
388
4.2.4.4.4. Divi(en( 3oli$
In a -erio in !hich a -ro+it is generate, this -ro+it can #e retaine !ithin
the #usiness accounts, or istri#ute to the #usiness o!ners as a ivien
-ay$ent"
7ivien -ay$ents are a ca-ital transaction, rather than an e3-ense"
7iviens are usually -ai in cash an reuce the cash #alance !ithin the
#usiness"
Dhen a -ro+it is generate, it can #e retaine !ithin the #usiness accounts to
+inance e3-ansion an the re-lace$ent o+ assets, or it can #e -ai as a
ivien"
Businesses have varying -olicies regaring ivien -ay$ents"
#o dividend pa*ments
So$e #usinesses o not -ay iviens"
(enerally, in cases o+ start<u- o-erations, -erios o+ negative cash +lo!, an
high<gro!th inustries, all ca-ital is retaine !ithin the #usiness an
iviens are not -ai"
S$all an evelo-ing enter-rises o not usually -ay iviens, as all the
ca-ital generate +ro$ -ro+its is re&uire to sustain an evelo- the
o-eration"
Also, so$e large co$-anies have a -olicy o+ not -aying iviens, an
retaining all ca-ital to +un e3-ansion"
+ull dividend pa*ments
At the o--osite e3tre$e, so$e co$-anies -ay all -ro+its out as iviens"
This generally occurs in the case o+ #usinesses !ith sta#le long<ter$
o-erations, an little re&uire$ent or o--ortunity to +un e3-ansion or ne!
evelo-$ent"
Success+ul single<-rouct co$-anies that have evelo-e a sustaina#le
-osition !ithin a $arket can #e an e3a$-le o+ this"
381
In these cases, the #usiness o-erates in the sa$e !ay +ro$ year to year, !ith
inco$e #eing receive, e3-enses #eing -ai, an -ro+it #eing istri#ute as
ivien -ay$ents"
A #usiness o+ this ty-e can result in a long<ter$ regular inco$e strea$, an
$ay so$eti$es #e value in a si$ilar !ay to a +i3e<interest #on"
%3a$-les coul inclue a ata service su--lying in+or$ation to traing
o-erations, or a success+ul +oo -rouct #ase on a uni&ue reci-e, !here
sales settle at a sta#le level over a long -erio o+ ti$e"
Partial dividend pa*ments
The $a9ority o+ $eiu$ si@e an large co$-anies -ay out a -ro-ortion o+
-ro+its as iviens, an retain a -ro-ortion o+ -ro+its to +un re-lace$ent o+
assets an e3-ansion -rogra$s"
The -ro-ortion that is -ai out is kno!n as the :-ayout ratio;"
This can #e calculate using the +ollo!ing +or$ula
profit net
payment dividend
ratio payout
2or e3a$-le, a co$-any $ay have a net -ro+it o+ G1 +or a -erio, an $ay
istri#ute iviens o+ G)"
In this case, the -ayout ratio coul #e calculate using the +ollo!ing e3a$-le
1
)
ratio payout
8* 0.
8*
386
In the case o+ liste shares, this +or$ula $ay #e e3-resse in the +ollo!ing
+or$"
share per earnings
share per dividend
ratio payout
Sta"ilit* of dividends
It is co$$on -ractice to set the ivien -ay$ent to a conservative level"
This a--roach allo!s a si$ilar ivien to #e -ai each year, regarless o+
rises an +alls in -ro+it"
This $ay #e one +or several reasons"
Shareholers o not react +avoura#ly to the ivien #eing reuce, an so
the $anage$ent o+ large co$-anies generally only increases the ivien
-ay$ent !hen there is a vie! that a sustaina#le increase in -ro+it levels has
occurre"
This reuces the chance that iviens !ill have to #e reuce in +uture
years"
7ivien -ay$ents o not a++ect the total assets o+ the shareholers, as this
si$-ly trans+ers +uns +ro$ !ithin the co$-any to the iniviual
shareholerCs -ersonal na$e"
This is re+lecte in the +act that the share -rice +alls on the ay o+ the
ivien, #y an a$ount e&ual to the ivien -ay$ent"
(eneral traing an other issues such as ta3 e++ects $ay a++ect the actual
-rice $ove on the ay, ho!ever the si@e o+ the -rice +all is #ase on the si@e
o+ the ivien"
2ro$ a cash +lo! -ers-ective, the ivien is a cash -ay$ent that is use as
regular inco$e #y so$e shareholers, an +or this reason a sta#le level o+
iviens is -re+erre to one that rises an +alls #y large a$ounts"
310
4.2.4.5. ' omparison of fun(ing strutures
The +ollo!ing ta#le -resents three i++erent +uning arrange$ents +or a
#usiness o-eration"
The asset in this e3a$-le has a value o+ G100, an generates a net inco$e o+
G20 +ro$ o-erations"
The +igures are given +or a +uning arrange$ent using e&uity only, e#t only,
an a lease +uning arrange$ent"
The e3a$-le assu$es that the interest rates on the e#t an the lease are the
sa$e, an that the -rinci-al co$-onent o+ the a$ortising lease is e&ual to the
e-reciation a$ount"
Balance Sheet Balance Sheet Leased Assets
1wned Assets 1wned Assets
()uit* +unded De"t +unded
Assets
%&ui-$ent 100 100 0
/ash *0 *0 *0
Total Assets 1*0 1*0 *0
,ia#ilities
7e#t 0 100 0
4et assets 1*0 *0 *0
A-erating inco$e 20 20 20
7e-reciation 10 10 0
Interest e3-ense 0 * 0
,ease e3-ense 0 0 1*
4et inco$e 10 * *
(earing 0 L )) L 0 L
Return on Assets )"8 L 3"3 L 10 L
Return on %&uity )"8 L 10 L 10 L
311
This e3a$-le illustrates the care that $ust #e taken in inter-reting the :return
on assets; an :return on e&uity; +igures o+ a #usiness o-eration"
In all three cases, the sa$e -hysical assets are use an the sa$e o-erations
are -er+or$e, ho!ever these +igures are !iely i++erent e-ening on the
+uning arrange$ent use"
4.2.5. E)pense an( apital (eisions
A nu$#er o+ a--roaches $ay #e taken in eciing !hether to incur various
e3-enses, or invest in -ro9ects, +acilities or e&ui-$ent"
This $ay involve so$e o+ the +ollo!ing a--roaches, e-ening on the
-articular circu$stances"
4.2.5.1. ,eturn on investment
In so$e cases, the inco$e that $ay +lo! as the result o+ a ca-ital invest$ent
$ay #e irectly esti$ate"
This $ay a--ly in the case o+ ne! -rouct evelo-$ents, +or e3a$-le, !here
esti$ates $ay #e $ae o+ the long<ter$ sales o+ a ne! -rouct"
This situation $ay also a--ly in the case o+ evelo-$ent -ro9ects that $ay #e
sol, either to a s-eci+ic client !ho $ay re&uest a evelo-$ent, or in the
general $arket"

In cases such as these, a net<-resent<value a--roach $ay #e use to
eter$ine an e++ective return +ro$ the -ro9ect"
The internal rate o+ return +ro$ the -ro9ect $ay #e calculate, -articularly in
cases that $ay involve a single -ay$ent at the #eginning or en o+ the
-ro9ect"
Alternatively a iscount rate incor-orating a risk -re$iu$, or a target hurle
rate o+ return, $ay #e use to eter$ine a net -resent value +or the -ro9ect"
312
These a--roaches are #ase on iscounting +uture e3-enses an inco$e o+
the -ro9ect to -resent values, to eter$ine an e++ective value o+ the -ro9ect or
an e++ective return on the ca-ital that is investe"
4.2.5.2. 's re9uire(
In -ractice, so$e e3-enses $ay #e necessary in orer to continue an e++ective
#usiness o-eration, regarless o+ issues o+ invest$ent returns"
2or e3a$-le, changes in govern$ent regulations $ay re&uire changes in
a$inistration -roceures, -rouct esigns or #usiness activities"
As another e3a$-le, a ne! -rouct $ay not #e a#le to #e e++ectively
a$inistere until a co$-uterise a$inistration syste$ has #een !ritten to
-rovie the a$inistration storage an -rocessing +unctions"
=o!ever, this a--roach $ay nee to #e use !ith caution"
A !ie range o+ e3-enses $ay #e consiere :necessary;"
In reality, very little is actually necessary"
Manu+acturing coul #e -er+or$e using han asse$#ly an #asic tools,
!hile #usiness -rocesses coul #e -er+or$e using -a-er an -encils"
A large nu$#er o+ #usiness activities $ay #e evote to t!o +una$ental
+unctions
These $ay #e
Increasing e++iciency
Risk $anage$ent
%++iciency $ay involve a !ie range o+ issues" This $ay inclue so$e o+ the
+ollo!ing -oints"
The accuracy an &uality control o+ co$-lete -roucts"
The cost o+ -roucing each ite$"
313
The volu$e o+ ite$s that $ay #e -rouce !ithin a ti$e -erio,
+ro$ +acilities o+ a -articular si@e an cost"
The ti$e elay that $ay #e re&uire #et!een a clientCs custo$ise
orer #eing loge, an the ite$ #eing availa#le +or the client"
The ca-ital value an invest$ent re&uire to create, o-erate an
$aintain the #usiness activity"
%ach e3-ense or ca-ital e3-eniture ecision $ay nee to #e assesse in the
light o+ the i$-act that it $ay have on so$e o+ the -revious -oints"
4.2.5.3. 1eneral business impat
So$e e3-enses, -ro9ects an activities $ay nee to #e assesse in ter$s o+
their overall i$-act on the #usiness activity"
This $ay inclue re<structuring the #usiness o-erations into i++erent areas
an structures, avertising ca$-aigns, ne! co$-uter +acilities an so+t!are,
internal evelo-$ent -ro9ects, u-ating #usiness activities an so on"
4.2.5.4. /i)e( bu(get
In so$e situations, an e3-ense $ay not involve a single +i3e a$ount"
In these cases, a +i3e #uget $ay #e allocate +or a -articular e3-ense, an
o-erations $ay continue until the e3-ense #uget has #een use"
2or e3a$-le, a -ro9ect $ay esti$ate that the cost o+ creating a ne! -rouct
+or a ne! $arket $ay #e G10"
A ecision $ay then #e $ae to allocate an avertising #uget o+ hal+ the
evelo-$ent e3-ense, or G*"
This $ay #e -artly an ar#itrary ecision, !ith either a large or s$all #uget
allocation #eing -ossi#le"
In contrast, a transaction such as -urchasing an ite$ o+ e&ui-$ent $ay
involve a +i3e cost, !hich $ay #e assesse in light o+ the costs an -otential
#ene+its"
310
This a--roach $ay also #e use in cases such as -rouct re+ine$ent an
i$-rove$ent"
A re+ine$ent an i$-rove$ent -rocess $ay #e -otentially unli$ite, an
coul continue in theory +or ever"
=o!ever, a li$it $ay nee to #e -lace on activities such as these, to -revent
costs #eco$ing e3cessive, an to ensure that a -rouct is actually co$-lete
an $ay #e use or launche"
2or e3a$-le, a evelo-$ent -rocess $ay involve a 12 $onth -erio in
creating a -rouct esign"
2ollo!ing this -rocess, a ecision $ay #e $ae to allocate another t!o
$onths o+ evelo-$ent ti$e, in orer to re+ine an i$-rove the -rouct
esign"
2ollo!ing this -rocess, the esign $ay #e +ro@en an -rouction $ay
co$$ence"
4.2.!. #truture( transations
A structure transaction $ay involve a transaction that inclues a nu$#er o+
i++erent co$-onents"
2or e3a$-le, an asset $ay #e sol in co$#ination !ith a e#t +acility, as a
single transaction"
This arrange$ent $ay #e si$ilar to raising e#t irectly to -urchase an asset"
=o!ever, a nu$#er o+ avantages an isavantages $ay #e involve in
using a structure transaction"
Structure transactions $ay #e arrange #y invest$ent #anks, +inancial
service organisations such as #anks, stock #rokers, an sellers o+ assets"
This ty-e o+ arrange$ent $ay #e use +or very large transactions, such as the
+uning o+ in+rastructure assets such as air-orts, an also +or s$all
transactions at the retail level, involving $e$#ers o+ the general -u#lic"
31*
4.2.!.1. T$pes of struture( transation
Ane a--roach $ay involve -ackaging an asset an a e#t +acility !ithin a
single transaction"
This $ay #e arrange #y a +inancial services organisation, or #y the seller o+
an asset"
Ather ty-es o+ structure transactions $ay inclue -ackaging o+ o-tions an
+utures instru$ents into transactions that $ay #e -urchase irectly through a
retail arrange$ent, as a +or$ o+ risk $anage$ent against $arket -rice
$oves"
2or e3a$-le, a -ro-erty invest$ent transaction $ay inclue the sale o+ a
-ro-erty, the loan use to -urchase the -ro-erty, an an o-tion to reuce the
risk o+ interest rates rising a#ove a s-eci+ie level"
Another e3a$-le $ay involve the venor +inancing the sale o+ a #usiness,
!ith the #usiness seller -roviing the +inancing +or the #usiness -urchase"
4.2.!.2. '(vantages of struture( transations
Convenience
A structure transaction $ay avoi a consiera#le a$ount o+ ti$e an e++ort
that $ay #e involve in arranging the various co$-onents o+ the transaction"
In so$e cases, a structure transaction $ay #e arrange si$-ly #y $aking
the relevant -ay$ents an signing the relevant ocu$ents, in contrast to
so$e asset transactions that $ay e3ten over several $onths as various
ocu$ents are arrange an various ste-s in the -rocess are conucte"
Availa"ilit*
In so$e cases, a +acility or +eature $ay #e availa#le !ithin a structure
transaction $ay not #e availa#le through other sources"
2or e3a$-le, although +utures an o-tions $ay #e trae #y the general
-u#lic, a range o+ -ractical issues such as $argin accounts an $ini$u$
contract si@es $ay lea to this a--roach #eing co$-le3 in situations !here
only one or t!o transactions $ay #e conucte"
31)
In other cases, +inancial instru$ents such as :s!a-s; $ay #e trae in large
cor-orate $arkets, an $ay not #e availa#le in the si@e that $ay #e
a--lica#le to iniviuals or s$all enter-rises"
(conomies of scale
In so$e cases, costs !ithin a structure transaction $ay #e lo!, ue to
econo$ies o+ scale"
2or e3a$-le, a +inancial services organisation $ay raise a large su$ o+ e#t
to +un a $a9or transaction, !ith the interest rate -ossi#ly #eing lo!er than
the interest rate that $ay #e availa#le through irect iniviual #orro!ing"
2i3e costs such as legal +ees an registration costs $ay also #e s-rea across
all holers o+ the structure transaction, rather than #eing +ully #orne #y the
#usiness itsel+"
Credit assessment
So$e structure transactions $ay not re&uire a creit assess$ent o+ the
#usiness, !hile in other cases a #asic creit assess$ent $ay #e conucte,
that $ay involve lo!er re&uire$ents that a irect loan arrange$ent"
This $ay occur ue to the +act that a structure transaction $ay involve an
asset !ithin the structure #eing hel as security +or the e#t, an $ay also
involve cash +lo! +ro$ the structure #eing auto$atically irecte to!ars the
e#t re-ay$ent"
A lack o+ creit assess$ent $ay avoi the ti$e an e++ort that $ay #e
involve in a stanar creit assess$ent -rocess, an $ay also #e use+ul in
cases !here the #usiness $ay #e una#le to raise e#t irectly"
Limited recourse de"t
So$e structure transactions $ay involve a :li$ite recourse; e#t
arrange$ent"
In this case, the security +or the e#t $ay #e li$ite to the assets that are hel
!ithin the structure"
This $ay reuce the risk e3-osure +or the #usiness"
318
In the case o+ insolvency, i+ the sale o+ the assets !ithin the structure oes not
raise su++icient +uns to re-ay the entire e#t, then the re$aining e#t $ay
not #eco$e an aitional e#t to the #usiness"
Gearing levels
Structure transactions $ay have high gearing levels"
This $ay occur ue to the asset security e$#ee !ithin the structure, the
-ossi#le re<irection o+ cash +lo! to e#t servicing, an -ossi#ly +eatures
such as o-tions that $ay reuce the risk o+ the structure +ailing, an losses
occurring to the #usiness or the lener"
This arrange$ent $ay #e use+ul in -reserving the e3isting ca-ital o+ the
#usiness, rather than re&uiring ca-ital to #e allocate to e-osits, $argins or
-artial -ay$ent o+ assets hel !ithin the structure"
4.2.!.3. Disa(vantages of struture( transations
A nu$#er o+ isavantages $ay also a--ly to these ty-es o+ structures"
+ees
In so$e cases, the total cost o+ a structure transaction $ay #e lo!er than the
e&uivalent cost o+ arranging the transaction irectly, ue to econo$ies o+
scale that $ay #e involve in arranging the -ackaging"
=o!ever, in other cases, large +ees an co$$issions $ay #e e$#ee
!ithin the structure o+ the transaction"
Dhere -ossi#le, a co$-arison $ay #e $ae !ith an e&uivalent transaction
that $ay #e arrange irectly, to esti$ate the cost<e++ectiveness o+ the
-ackage transaction"
=o!ever, in the case o+ co$-le3 structures, irect co$-arisons $ay not #e
-ractical, an the cost o+ a transaction $ay nee to #e assesse in light o+ the
-otential #ene+its o+ the transaction an the likely return +ro$ the structure"
In so$e cases, the cost o+ various co$-onents $ay #e s-eci+ie !ithin the
-rouct escri-tion, inclue +ees an co$$issions relate to various
co$-onents o+ the structure, an relating to the structure itsel+"
311
+le%i"ilit*
Although a structure transaction $ay inclue several o-tional co$-onents
an selecta#le values, the structure o+ the transaction $ay not e3actly $atch
the structure that the #usiness $ay chose i+ it !as arranging the transaction
irectly"
2eatures $ay #e inclue that $ay re&uire a cost, ho!ever the #usiness $ay
not !ish to inclue those +eatures in a transaction"
In other cases, +eatures $ay #e $issing that $ay #e esire, or various
restrictions, early !ithra!al -enalties, an other conitions $ay a--ly"
Also, in general the entire structure $ay nee to #e un!oun as a single
action"
In the case o+ transactions in !hich the co$-onents are arrange
iniviually, it $ay #e -ossi#le to alter each co$-onent iniviually as ti$e
-asses"
In so$e situations, a structure transaction $ay #e a less +le3i#le alternative
than arranging the co$-onents o+ a transaction iniviually"
".!. 6ar+eting & Distribution
4.3.1. -ar6eting
Marketing involves generating sales o+ the #usinessCs -roucts an services"
This inclues so$e o+ the +ollo!ing areas"
5rouct esign Involve$ent in selecting the #roa range o+
-roucts to #e -rouce #y the #usiness, incluing
the ty-e o+ -rouct, the volu$es -rouce, the
e3-ecte or target grou- o+ custo$ers, an the
si@e an co$-le3ity o+ the ite$s"
316
Market -osition Selecting the area o+ the $arket to o-erate in" 2or
e3a$-le, a #usiness $ay -rouce lo!<cost #asic
ite$s, custo$ise ite$s, +ull<service or iscount<
service o-erations, high<risk creit or lo!<risk
creit, an so +orth"
5ro$otion Arganising avertising an -ro$otion activities in
re+erence to the general -u#lic, an organising
-ro-osals, teners an su#$issions +or other
#usinesses or large clients"
Sales 7ealing irectly !ith custo$ers en&uiring a#out
or re&uesting -roucts or services"
Market evelo-$ent 7evelo-ing ne! $arkets +or the #usinessCs
-roucts, such as introucing a ne! -rouct to an
e3isting $arket, or evelo-ing a ne! client #ase
in another geogra-hical location
4.3.1.1. 3ro(ut (esign
5rouct esign +ro$ a $arketing -ers-ective $ay involve selecting -rouct
esigns that !ill $eet e$ans +ro$ -otential custo$ers"
This is one in-ut to the -rouct esign -rocess"
In so$e cases, a +eature or as-ect o+ a esign $ay have little i$-act on the
custo$er, an $ay #e i++icult or e3-ensive to inclue !ithin the co$-lete
-rouct"
In other cases, a $inor change $ay #e relatively si$-le to i$-le$ent, #ut
$ay -rovie a signi+icant i$-rove$ent in the -rouct +ro$ the custo$erCs
-ers-ective"
A success+ul -rouct $ust #e #oth attractive +ro$ the custo$erCs -ers-ective,
$ust also #e a#le to #e -rouce e++iciently an in a -ractical !ay"
360
4.3.1.2. -ar6et position
Market -osition involves selecting the -art o+ the $arket to o-erate in"
2or e3a$-le, a #usiness $ay -rouce light +ittings"
The $arket +or light +ittings $ay inclue a nu$#er o+ i++erent areas"
This coul inclue high<volu$e, lo!<cost light +ittings +or co$$ercial
#uilings such as s$all !arehouses, higher &uality ite$s +or househol use,
custo$ise light +ittings +or -articular -ur-oses, or s-eci+ic iniviual
esigns"
Selecting the $arket -osition !oul involve eciing !hich ty-e o+ +ittings
to -rouce an !hich area o+ the $arket to o-erate in"
This ecision $ay #e #ase on the resources availa#le to the #usiness, the
si@e o+ each $arket seg$ent, $argins an co$-etition in each $arket
seg$ent, an the interests an long<ter$ -re+erences o+ the #usiness o!ners"
4.3.1.3. 3romotion
Businesses generally eal !ith either the general -u#lic, or a relatively s$all
nu$#er o+ clients or other #usinesses"
In the case o+ the general -u#lic, -ro$oting the #usiness $ay involve
organising avertising ca$-aigns, -ro$otion activities such as co$-etitions
an s-ecial o++ers, an rising the -ro+ile o+ the #usiness through other
activities such as involve$ent in con+erences, e3hi#itions an events"
In the case o+ a s$aller grou- o+ clients or custo$ers, this $ay involve
-re-aring !ritten teners or -ro-osals, giving -resentations to -otential
clients, an ensuring that the #usiness a--ears !ithin inustry events such as
#usiness surveys an trae +airs"
5re-aring teners an -ro-osals can #e a signi+icant task"
In so$e cases, several $onths !ork $ay #e involve in -re-aring a single
su#$ission"
This task $ay involve in-ut +ro$ a nu$#er o+ -eo-le incluing $arketing
sta++, technical sta++, an other -arties such as -rouct $anagers"
361
The stakes $ay also #e high in these cases, as in so$e inustries the entire
inustry $ay #e co$-ose o+ t!o or three -otential clients"
In the cases o+ a re9ecte su#$ission, the #usiness can loge another -ro-osal
!ith the -otential client at a later ate"
=o!ever, a -erio o+ si3 to t!elve $onths $ust generally -ass #e+ore a
#usiness can su#$it a ne! -ro-osal to a client !ho has revie!e a -ro-osal
an ecline to -artici-ate"
Avertising an -ro$otion activities are generally organise in con9unction
!ith an avertising or -ro$otions agency"
Avertising agencies esign avertising ca$-aigns in con9unction !ith the
client, an organise the actual -rouction o+ $aterial an a--earance o+ the
-rouct, such as a $aga@ine avertise$ent"
5ro$otion agencies organise -ro$otion activities such as istri#uting sa$-le
-roucts at $a9or events"
4.3.1.4. #ales
Sales involves ealing !ith custo$ers an clients uring the -rocess o+
conucting an actual -urchase transaction"
In so$e cases, -otential custo$ers or clients are a--roache irectly, an
aske !hether they !oul #e intereste in the #usinessCs -roucts or
services"
This a--roach is -articularly relevant to ne! #usinesses o-erating in an
esta#lishe $arket, an to cases !here a ne! an un+a$iliar -rouct is
introuce"
=o!ever, in general a custo$er a--roaches the #usiness in orer to -urchase
a -rouct or service"
This $ay #e erive +ro$ so$e o+ the +ollo!ing sourcesE
A res-onse to avertising"
Dor<o+<$outh in+or$ation"
362
In+or$ation locate +ro$ a irectory such as a tele-hone #ook or
on<line service"
A general res-onse to the -ro+ile o+ a #usiness !ithin a s$all
inustry"
/ontract +ollo!ing a -revious -urchase +ro$ the sa$e #usiness"
The sales -rocess $ay involve e$onstrating ite$s an res-oning to
custo$er &uestions, a+ter !hich the custo$er !oul $ake a ecision to
-urchase the -rouct or to ecline to -urchase the -rouct"
4.3.1.5. -ar6et (evelopment
Market evelo-$ent involves creating ne! client #ases an $arkets +or the
#usinessCs -roucts an services"
This $ay involve introucing the -roucts or services to a ne! geogra-hic
region, such as interstate or overseas sales"
%3-aning the #usinessCs o-erations into a !ier area is one o+ the $a9or
+una$ental !ays that #usiness e3-ansion can occur"
This $ay involve iscussions !ith -otential istri#utors o+ the -roucts"
This -rocess $ay involve so$e o+ the +ollo!ing activitiesE
Su--lying -rouct s-eci+ications an sa$-les"
5roviing in+or$ation to su--ort the a#ility o+ the #usiness to
su--ly the -roucts in the necessary volu$es on a relia#le #asis"
4egotiating su--ly agree$ents"
In the case o+ irect sales, this $ay involve a--roaching -otential custo$ers,
an organising avertising an -ro$otion activities"
Dhen ne! -roucts are introuce, a consiera#le lea ti$e $ay #e involve
in evelo-ing a $arket +or the ne! -rouct"
363
This $ay involve $ail<outs o+ in+or$ation to e3isting custo$ers, avertising
an -ro$otion, an contacting -otential custo$ers irectly to su--ly -rouct
s-eci+ications an sa$-les"
4.3.2. Distribution
A !ie range o+ $ethos are use to istri#ute -roucts +ro$ the #usiness to
the custo$ers !ho -urchase the -rouct"
%++ective istri#ution is a $a9or co$-onent o+ the success or +ailure o+ a
#usiness enter-rise"
7istri#ution involves a -rocess #y !hich the -roucts or services can #e
-resente to a custo$er +or -otential -urchase"
This $ay involve retail stores, on<line or $ail orer, an thir<-arty
istri#ution through the activities o+ other #usinesses"
4.3.2.1. +lose( (istribution .annels
Be+ore the ecision to -urchase a -rouct can #e $ae #y a custo$er, the
-rouct $ust #e reaily availa#le to the custo$er"
This $ay #e a $a9or challenge, as in so$e cases this cannot #e irectly
controlle #y the #usiness"
2or e3a$-le, a $anu+acturer o+ clothing $ay +in that the e-art$ent stores
an +ashion #outi&ues that the #usiness contracts ecline to carry the -roucts
as stock"
5roucts sol through su-er$arkets are another e3a$-le o+ this"
Shel+ s-ace on su-er$arket shelves is hotly conteste"
Si$-ly -lacing an ite$ on the sel+ o+ a su-er$arket, at a reasona#le -rice,
$ay #e su++icient to result in a steay strea$ o+ sales"
/onversely, i+ a $a9or su-er$arket chain ecline to carry a -rouct then
this $ay have a large i$-act on sales"

360
,ong<ter$ agree$ents !ith su--liers an su-er$arkets $ay e3ist +or the
allocation o+ li$ite shel+ s-ace, an in so$e situations the su--lier $ay -ay
a +ee to the su-er$arket to allo! the -rouct to #e hel on their shelves"
Accessing close istri#ution channels $ay involve a consiera#le ti$e
elay, an $ay involve -roviing -rouct s-eci+ications to istri#utors,
-roviing sa$-les, o++ering iscount -erios an su#siies +or a li$ite ti$e,
an creating a -ro+ile +or a -rouct"
2or e3a$-le, istri#utors $ay #e $ore intereste in carrying a -rouct i+
there is a custo$er e$an +or the -rouct, or i+ the -rouct has alreay
esta#lishe signi+icant sales through other channels"

4.3.2.2. -et.o(s of (istribution
4.3.2.2.1. Diret to publi
7irect sales to the -u#lic inclue a !ie range o+ #usiness activities !here
$e$#ers o+ the -u#lic -urchase goos an services irectly +ro$ the
#usiness"
The inclues retail stores, ho$e services, services such as $eical, legal an
accounting, an utilities such as gas, electricity an tele-hone services"
Trans-ort, such as air travel, is another e3a$-le o+ irect sale to the -u#lic"
7irect sales to the -u#lic are a si$-le a--roach that avois the nee to
negotiate !ith istri#utors"
This allo!s the -urchase ecision to #e $ae irectly #y the en custo$er"
5rices $ay #e lo!er than in the case o+ inirect istri#ution, ue to the +act
that co$$issions an -ay$ents to istri#utors are not re&uire"
=o!ever, this a--roach also has isavantages"
In these cases, avertising an other -ro$otions $ust #e use to $ake the
-rouct visi#le an to generate sales"
Avertising can #e e3-ensive an a #usiness that eals !ith the -u#lic at
large $ay +in that signi+icant ca-ital e3-enses are neee to create a
su++icient -ro+ile to result in a steay strea$ o+ sales"
36*
/osts relate to a$inistration, custo$er service, -roviing is-lay s-ace
an so +orth $ay #e higher !hen irect sales are use, rather than !hen
-roucts are sol through other channels"
Also, this a--roach is only a--lica#le to goos an services that are
-urchase irectly #y iniviuals"
4.3.2.2.1.1. Diret aess
7irect access inclues retail stores, #usinesses that o-erate +ro$ o++ices, an
#usinesses that co$e irectly to a ho$e such as trae services"
4.3.2.2.1.2. Telep.one aess
Tele-hone access inclues utilities such as gas an electricity su--ly, ata
services an so +orth, !here contract #et!een the custo$er an the #usiness
usually occurs through large volu$e tele-hone call access"
4.3.2.2.1.3. -ail or(er
Mail orer is a lo!<cost istri#ution syste$ that involves custo$ers orering
+ro$ catalogues or avertising in+or$ation, +or irect elivery o+ the -rouct"
This $etho can #e set u- !ith very little ca-ital an a si$-le o-eration, an
can hanle either s$all or large volu$es o+ trae"
Mail orer also involves +e! +i3e costs such as lease #uiling s-ace"
=o!ever, custo$ers o not get the o--ortunity to e3a$ine the -roucts, an
they o not generally have the o--ortunity to iscuss the -roucts or raise
&uestions a#out the goos"
Mail orer istri#ution can #e create !ithout great i++iculty, ho!ever the
success o+ a #usiness that o-erates on this #asis re&uires that -roucts can #e
elivere at a -rice that is signi+icantly #elo! the -rice o+ e&uivalent goos
that are availa#le in retail stores"
Mail orer also has a very lo! res-onse rate, !ith re-lies to $arketing
$aterial #eing a +e! -ercent or less o+ the volu$e o+ in+or$ation istri#ute"
36)

4.3.2.2.1.4. On*line
An<line istri#ution involves avertising an istri#ution through internet
an other on<line access $ethos"
This is si$ilar to a $ail orer a--roach in that the custo$er oes not have
-hysical contract !ith the #usiness or !ith the goos #e+ore they are
-urchase"
=o!ever, a consiera#le a$ount o+ in+or$ation $ay #e inclue a#out
-roucts in an on<line site"
This $ay inclue technical etails an s-eci+ications, -hotogra-hs o+
-roucts, an even vieo se&uences, such as a short se&uence is-laying the
roo$s an +acilities o+ a hotel or a -ro-erty +or sale"
Although ite$s cannot #e -hysically ins-ecte through on<line sites, an
&uestions concerning -roucts cannot generally #e aske, in+or$ation o+ this
ty-e $ay not #e availa#le though a irect retail arrange$ent"
/reating an e++ective on<line istri#ution site $ay involve signi+icant
e3-ense"
In the case o+ a s$all nu$#er o+ -roucts, this arrange$ent can #e create
+airly easily"
=o!ever, i+ the #usiness -rouces a !ie range o+ -roucts, an the
orering, -ay$ent an inventory $anage$ent are integrate into the on<line
access syste$, a signi+icant invest$ent in ca-ital $ay #e re&uire to create
an $aintain the service"
An<line access has the avantage o+ allo!ing an e3tre$ely large nu$#er o+
-otential custo$ers to access the in+or$ation concerning the -rouct an to
orer -roucts"
An<line access also allo!s +or international sales !ithout any aitional
$arketing an evelo-$ent e3-enses"
In so$e cases, #usinesses o++ering a $a9or on<line -resence $ay +in that the
$a9ority o+ their sales are to overseas custo$ers, an they $ay sell very +e!
-roucts !ithin the ho$e country o+ the #usiness itsel+"
368
7isavantages o+ this a--roach inclue the +act that the -roucts cannot #e
-hysically ins-ecte #e+ore -urchase"
Also, the on<line site $ay not #e accesse unless traitional avertising an
other a--roaches are also use to raise the -ro+ile o+ the -roucts a$ong
custo$ers"
An<line -roucts can #e co$-are very &uickly an easily against
co$-etitorCs -roucts an -rices, an this $ay result in -rices #eing highly
co$-etitive #et!een alternative su--liers"
4.3.2.2.2. Diret to ot.er businesses
A large nu$#er o+ -roucts are sol to other #usinesses rather than to
iniviuals"
This inclues $ining -roucts, agricultural -roucts, e&ui-$ent, an
#usiness services"
In the case o+ large -ro9ect evelo-$ents, such as co$$ercial construction
an co$-uter so+t!are evelo-$ent, the #usiness $ay eal irectly !ith a
s$all nu$#er o+ clients"
Avertising is less i$-ortant in this $arket, !ith -rice, &uality an relia#ility
o+ su--ly #eing $a9or issues"
/o$$unication $ay #e irect #et!een the #usiness an the custo$ers"
4e! #usinesses an ne! -rouct areas $ay a--roach -otential custo$ers
!ith sa$-le -roucts an -rouct in+or$ation, an atte$-t to negotiate on<
going su--ly agree$ents, or su--ly s$all volu$es o+ sa$-le goos on a trial
#asis"
Also, $any inustries o-erate !ith a three<tiere structure"
In this situation, -roucers su--ly -roucts to !holesale istri#utors, the
!holesale istri#utors su--ly retail istri#utors, an the retailers sell the
-roucts irectly to the -u#lic"
In this situation, istri#ution $ay involve ealing !ith a s$all nu$#er o+
!holesale istri#utors"
361
2or e3a$-le, +ruit an vegeta#le gro!ers $ay su--ly !holesale istri#utors,
!ho in turn $ay su--ly iniviual retail o-erations"
Both the !holesale an retail istri#utors in this case o-erate istri#ution
#usinesses"
4.3.2.2.3. 4n(ivi(ual 'gents
So$e -roucts an services are sol through agents !ho re-resent the
-roucts to -otential custo$ers"
Insurance has traitionally #een sol in this !ay"
/usto$er contact $ay co$e +ro$ a--roaches #y the agent, such as oor<to<
oor, col calling +ro$ lists o+ na$es an contact etails, or through re+erral
#y another iniviual"
2or e3a$-le, in a real estate transaction, the real estate agency $ay re+er the
-otential client to an insurance agency"
A--roach $ay also co$e +ro$ the custo$er, res-oning to avertising, or
through general en&uiries +or -roucts or services"
Agents can #e tie, in !hich case that o-erate +or a single organisation only,
or ine-enent, !here they o-erate +or a range o+ i++erent organisations"
Agents can #e -ai a salary, !hich !oul nor$ally inclue a large varia#le
co$-onent #ase on the nu$#er o+ sales"
In other cases the agent receives a co$$ission +ee +or each -rouct that is
sol"
In so$e cases +i3e +ees a--ly, !hile in other cases the co$$ission or +ee is
#ase on a -ercentage o+ the si@e o+ the transaction"
The ter$ :agent; in this conte3t a--lies to situations !here an iniviual
istri#utes -roucts or services that are -rouce #y a se-arate organisation"
This is i++erent +ro$ the use o+ the ter$ !ithin inustries such as real estate,
!hich involve -roviing a service irectly in return +or a +ee"
Also, the ter$ :agent; is i++erent in the legal conte3t, !ith the legal ter$
:agent; re+erring to a -arty that has #een grante authority to act on another
366
the -ersonCs #ehal+ an conuct legally #ining transactions, such as signing
contracts uner a -o!er o+ attorney"
4.3.2.2.4. T.ir(*part$ (istribution
Thir -arty istri#ution occurs !hen a #usiness has a stanar #usiness
o-eration, #ut also acts as an agent an istri#utes -roucts +or other
organisations"
2or e3a$-le, a #ank $ay conuct general #anking services, an also
istri#ute invest$ent -roucts through irect $ail to custo$ers an
iscussions !ith custo$ers concerning general +inancial issues"
Thir -arty istri#ution is a $a9or istri#ution $etho +or +inancial services
-roucts such as insurance an invest$ent -roucts"
4.3.2.2.5. #ub*lease( spae
In so$e situations, a #usiness can arrange is-lay s-ace that is su#<lease
+ro$ a larger +acility"
2or e3a$-le, so$e retail o-erations are #ase on a su#<leasing $oel"
This a--roach involves the $ain #usiness o-erator leasing the +acility an
arranging services an avertising"
The iniviual #usiness then su#<leases s-ace !ithin the +acility +ro$ the
$ain #usiness o-erator"
Market stalls are another e3a$-le o+ this istri#ution $etho"
This $etho is use +or +ruit an vegeta#le $arkets, irect istri#ution o+
-roucts to the -u#lic, an cra+t ite$s"
In this situation, the $arket o-erator arranges the +acilities an avertising
an organises the $arket"
Iniviuals an #usinesses can then -ay a +ee to o-erate a stall !ithin the
$arket"
000
4.3.2.2.!. 3a6age( pro(uts
In so$e cases, several -roucts $ay #e -ackage into a single -rouct"
This $ay occur in the case o+ so$e services, +or e3a$-le"
In cases such as these, the #usinessCs -roucts $ay #e use #y other
#usinesses +or inclusion !ithin a structure transaction, or a -ackage service
arrange$ent"
4.3.2.2.7. -ar6ets an( autions
So$e #usiness -roucts are sol in o-en $arkets through e3changes or
auction -rocesses"
2or e3a$-le, this $ay occur in the case o+ agricultural -roucts, so$e
$ining -roucts, an so on"
4.3.2.2.8. +o*bran(ing
/o<#raning occurs !hen a -rouct is -rouce that carries t!o #ran
na$es"
2or e3a$-le, an association or organisation $ay arrange !ith a #usiness to
su--ly -roucts uner its o!n na$e, !ith the #usiness #ran na$e also
a--earing on the -rouct"
In this situation, istri#ution activities $ay #e hanle #y the other
organisation"
4.3.2.2.9. +ontrat manufaturing an( 5.olesale servies
In the case o+ contract $anu+acturing an !holesale services, -rouction $ay
occur on #ehal+ o+ another #usiness"
001
2or e3a$-le, another #usiness $ay hols #ran na$es, create -rouct
esigns an -er+or$ $arketing activities, #ut $ay not have in<house
$anu+acturing or service elivery +acilities"
In these cases, the #usiness $ay -er+or$ the actual -rouction or service
elivery"
7esigns $ay #e su--lie #y the other #usiness, or a stanar set o+ -roucts
or services $ay #e su--lie"
This situation $ay also occur in the case o+ seasonal #usinesses, an in
situations !here another #usiness $ay not have su++icient -rouction
ca-acity to $eet custo$er orers, ue to strong e$an or -ro#le$s !ith in<
house -rouction +acilities"
4.3.2.2.1". 4nternational (istribution
International istri#ution involves e3-orting -roucts to +oreign countries"
This occurs in the case o+ large<scale $anu+acturing, an also in -ri$ary
-rouction such as agricultural an $ining -roucts"
S$all enter-rises $ay also #e involve in e3-orting -roucts"
2or e3a$-le, an enter-rise $ay -rouce a range o+ traitional +oos"
This enter-rise coul then e3-ort the -rouct to custo$ers in various -arts o+
the !orl"
In other cases, a -rouct $ay +in e$an in overseas $arkets i+ it is
-articularly unusual or innovative"
So$e ite$s, such as so$e s-ecialise ite$s o+ e&ui-$ent, are only
$anu+acture in a +e! -laces aroun the !orl an are e3-orte to other
countries"
In general, irect sale to the -u#lic in +oreign countries !oul not usually #e
+easi#le ue to the li$ite return +ro$ the costs o+ avertising an -ro$otion"
In so$e cases, an i$-orter in a +oreign country $ay -urchase the #usinessCs
-roucts an arrange istri#ution to retail outlets"
002
This a--roach allo!s the #usiness to eal !ith a single custo$er, an avoi
the cost an a$inistrative #uren involve in ealing irectly !ith the
-u#lic in another country"
Another a--roach $ay involve arranging thir<-arty istri#ution !ith a
+oreign istri#utor"

2or e3a$-le, agree$ents +or iscount rates an -ro$otions coul #e $ae
#et!een a hotel grou- an travel agency grou-s !ithin other countries that
!ere the source o+ regular tourist travel"
An<line access an orering can #e a $a9or ele$ent o+ e3-orting"
In so$e cases, #usinesses receive $ore on<line orers +ro$ overseas than
+ro$ local sales"
An<line access also has the avantage that no e3tra costs are involve !ith
international orers co$-are to local orers, a-art +ro$ shi--ing !hich $ay
#e -ai #y the custo$er"
003
4.3.2.2.11. #ummar$ of (istribution met.o(s
7irect to -u#lic Retail stores, o++ice #ase #usinesses such as
accountants, ho$e an trae services"
Tele-hone access Htilities such as gas an electricity, insurance"
Mail orer 5rouct catalogues"
An<line Internet sites allo!ing vie!ing -rouct etails
an orering -roucts"
7irect to clients or
#usinesses
Business activities that eal !ith a s$all
nu$#er o+ clients or #usinesses, such as
-ro9ect evelo-$ent o+ construction or
co$-uter so+t!are, #usiness services such as
-ro-erty $anage$ent an so on"
Iniviual agents Iniviuals !ho istri#ute -roucts irectly to
the -u#lic, such as insurance"
Thir<-arty istri#ution Ather #usinesses istri#uting the #usiness
-roucts to their custo$ers, in return +or
co$$issions or istri#ution +ees"
Su#<lease s-ace ,easing s-ace !ithin a larger retail store or
o-en $arket arrange$ent, as a $etho o+
is-laying ite$s to the -u#lic"
5ackage -roucts The #usinessCs -roucts #eing inclue in
-ackages asse$#le #y other #usinesses, such
as structure +inancial transactions, -ackage
services, an so on"
Markets . auctions Sale o+ -roucts through co$$oity
e3changes, auction -rocesses an so on" 2or
e3a$-le, agricultural -roucts $ay #e sol in
this !ay"
/o<#raning 5roucts are istri#ute !ith t!o #ran
na$es attache, the #usiness itsel+ an
another #ran, such as an association"
000
7istri#ution activities $ay #e -er+or$e #y
the other -arty"
/ontract $anu+acturing .
!holesale services
5roucts are -rouce on #ehal+ o+ another
#usiness, !ith the other #usiness -er+or$ing
the istri#ution activities"
International istri#ution %3-orting to +oreign regions, either irectly,
through a local i$-orter, or through a thir<
-arty istri#ution arrange$ent !ith a +oreign
o-erator"
00*
4.3.2.2.12. 3a$ment of (istributors
In cases !here istri#ution occurs inirectly, various -ay$ent $ethos can
#e use +or the istri#ution -ay$ent"
So$e inco$e arrange$ents +or istri#utors are liste #elo!
7irect sale The istri#utor -urchases the ite$ +ro$ the #usiness" The
istri#utor then o!ns the stock that is hel +or sale" The
inco$e to the istri#utor +lo!s +ro$ the i++erence #et!een
the -urchase -rice +ro$ the #usiness an the sale -rice to
the custo$er" This $etho is use in $ost retail o-erations,
a-art +ro$ large ite$s such as e&ui-$ent"
Agency 5ay$ent +lo!s irectly +ro$ the custo$er to the #usiness"
The istri#utor receives a +ee or co$$ission !hich $ay #e
a +i3e ollar a$ount, a -ercentage o+ the sale a$ount, or
so$e other arrange$ent" The istri#utor oes not -urchase
or o!n the stock that is hel +or is-lay" This $etho is
use +or thir<-arty istri#ution arrange$ents, an +or the
sale o+ large ite$s such as e&ui-$ent
Sale<or<return This $etho is use +or the sale o+ $aga@ines, +or e3a$-le"
The -u#lisher elivers the $aga@ines to the ne!sagent +or
is-lay, at no cost" Any -urchase ite$s result in -ay$ent
to the -u#lisher +ro$ the ne!sagent, !hile unsol ite$s are
returne"
4.3.2.2.13. 3ro(ut @ualit$
Ouality -roucts are the #est +or$ o+ -ro$otion that a #usiness can have"
A #usiness !ith &uality -roucts $ay +in that sales increase steaily !ith
little -ro$otion or $arketing e++ort"
7istri#utors $ay agree to carry the -roucts !ith little e++ort, an in so$e
cases a istri#utor $ay contact the #usiness an re&uest the right to istri#ute
the -roucts, rather than the o--osite situation occurring"
00)
5rouct &uality oes not necessarily i$-ly e3-ensive or co$-le3 ite$s"
There are se-arate $arkets +or #asic lo!<cost ite$s an e3-ensive co$-le3
ite$s in $ost -rouct grou-s"
A -rouct that +ills its +unction !ell !ith o+ten attract interest +ro$
istri#utors !ithout e3tensive e++orts +ro$ the #usiness"
%3tensive $arketing an -ro$otion can increase sales"
=o!ever, i+ this is #ase on -roucts that are not +una$entally attractive to
-otential custo$ers, then consiera#le cost an ti$e $ay #e involve +or
little return"
A #usiness that s-ens 60L o+ its resources on -rouct evelo-$ent an
10L on -ro$otion, $ay +in that it is $ore success+ul than a #usiness than
s-ens 10L on -rouct evelo-$ent an 60L on -ro$otion"
4.3.3. Distributing t.ir(*part$ pro(uts
In aitional to -er+or$ing the usual #usiness activities that the #usiness
conucts, the #usiness can also istri#ute other #usinessCs -roucts to its
custo$ers an clients"
This can -rovie aitional inco$e +or the #usiness, !ith little in-ut re&uire
to conuct the istri#ution activity"
Si$-ly having a steay strea$ o+ custo$ers $ay #e a valua#le asset to a
#usiness, an -rovies the o--ortunity to o++er relate -roucts or services to
custo$ers"
This -rocess generally involves -roucts that have a si$ilar #asis to the
#usinessCs o!n -roucts"
This ensures that the #usiness !ill have so$e kno!lege an unerstaning
o+ the -roucts, an also that the custo$ers are likely to #e intereste in
si$ilar -roucts"
2or e3a$-le, #anks o+ten istri#ute insurance an invest$ent -roucts, !hile
a real estate agency $ay istri#ute -ackage -ro-erty services to ne!
-ro-erty #uyers"
008
In so$e situations, the istri#ution activity $ay #eco$e a $a9or source o+
inco$e +or the #usiness, an the #usiness o-eration itsel+ $ay #eco$e less
signi+icant or $ay even #eco$e a loss<$aking o-eration"
4.3.4. Entr$ to mar6ets
In so$e cases, a #usiness $ay -rouce -roucts, avertise, an receive
i$$eiate orers +ro$ custo$ers"
=o!ever, in $ost cases signi+icant ste-s nee to #e taken to esta#lish a
-resence !ithin a $arket an to generate a steay strea$ o+ sales"
This a--lies to ne! #usinesses, an also to entering $arkets that a #usiness
has not o-erate in -reviously"
4.3.4.1. =e5 mar6ets
A $arket, in the conte3t o+ #usiness sales, is a ty-e o+ -rouct or service that
is sol in a -articular -lace, or in a -articular !ay"
4e! $arkets +or the #usiness activity can #e esta#lishe in so$e o+ the
+ollo!ing circu$stances"
7istri#uting the e3isting -roucts or services in ne! geogra-hic
regions"
/reating ne! -roucts or services !ithin the +ra$e!ork o+ the
e3isting #usiness o-erations"
/o$$encing o-erations in a ne! inustry, or evelo-ing -roucts
in a i++erent -rouct grou- +ro$ e3isting o-erations"
4.3.4.2. T$pes of mar6et entr$
Markets can #e entere graually, or through a $a9or -ro9ect activity"
001
Gradual entr*
(raually entry $ay #e an o-tion !here the #usiness has sta#le e3isting
o-erations"
This $ay allo! ne! -roucts to #e evelo-e an release, or $arketing
activities to co$$ence in ne! regions"
Marketing in ne! regions $ay -rouce a lo! volu$e o+ initial sales, !hich
$ay graually gro! into an esta#lishe client #ase or a steay strea$ o+
sales"
Pro2ect-"ased entr*
In $any circu$stances, ho!ever, graually entry $ay not #e a -ractical
alternative"
2i3e costs, such as leasing retail s-ace an o-erating a$inistration
activities, $ay lea to a $ini$u$ level o+ sales #eing neee to reach a
#reak<even -oint"
/o$$encing a s$all scale o-eration in these cases $ay result in signi+icant
losses ue to the out+lo! o+ +i3e costs"
Also, large e3-enses $ay #e re&uire to co$$ence o-eration"
These $ay inclue -urchasing a licence to o-erate !ithin an inustry, an the
cost o+ evelo-ing -roucts"
In these cases, a $ini$u$ level o+ sales !oul #e re&uire to recover the
costs o+ co$$encing o-erations"
A -ro9ect<#ase entry a--roach can #e use in situations such as this"
A -ro9ect<#ase entry involves a s-eci+ic -ro9ect, !ith the ai$ o+ either
reaching a sustaina#le level o+ sales !ithin a +i3e ti$e an !ithin a #uget
allocation, or a#anoning the atte$-t an !ithra!ing +ro$ the $arket"
4.3.4.3. +.oie of mar6et
The choice o+ !hich $arket to atte$-t ne! o-erations in $ay #e an
i$-ortant issue"
006
I+ the $arket +or the -roucts is too s$all, then the costs o+ esta#lishing the
o-eration $ay never #e recovere"
=o!ever, i+ the $arket is too large, then the #usiness ca-ital $ay #e &uickly
consu$e, !ithout creating a sustaina#le +lo! o+ sales"
This situation so$eti$es occurs in the case o+ overseas e3-ansion"
A #usiness $ay o-erate success+ully in an esta#lishe $arket"
The #usiness $ay then atte$-t to e3-an into a large overseas $arket"
=o!ever, the costs o+ avertising, evelo-ing custo$er su--ly arrange$ents
an leasing +acilities $ay &uickly consu$e the availa#le #usiness ca-ital"
This -rocess o+ten results in the #usiness retreating to the ho$e $arket,
having su++ere a $a9or loss in ca-ital"
The risk o+ this situation occurring can #e reuce #y care+ully selecting the
e3-ansion region, such as a single city or -art o+ another country as the target
#ase +or o-erations"
Averseas $arkets that are close to the local $arket are o+ten chosen +or this"
=o!ever, the $ost suita#le region $ay o+ten #e +ar istant +ro$ the #ase
country o+ o-eration"
I+ a #usiness ecies to esta#lish an overseas o-eration, then all -ossi#le
locations shoul #e consiere #e+ore a ecision is $ae"
4.3.4.4. 3ro(uts & servies
In orer to esta#lish o-erations in a ne! $arket, a #usiness !oul nee to
have -roucts or services that ha a reasona#le chance o+ success"
These $ay #e -roucts esigne an evelo-e internally, or they $ay #e
-rouces source +ro$ other #usinesses uner a istri#ution agree$ent"
The -rice, &uality, availa#le volu$e an $arket e$an +or the -rouct $ay
all #e issues that coul eter$ine !hether a -rouct ha a reasona#le chance
o+ success"
010
The e3isting or -lanne -roucts shoul generally #e care+ully assesse,
#e+ore any consieration is given to atte$-ting to esta#lish ne! o-erations"
I+ the e3isting or -lanne -roucts !oul not #e suita#le +or the ne! $arket,
then a -rouct evelo-$ent -rocess $ay #e re&uire #e+ore the -rocess o+
esta#lishing o-erations coul #e consiere"
I+ ae&uate -roucts are availa#le, then a -ro9ect -lan coul #e evelo-e on
the #asis o+ atte$-ting to esta#lish a sustaina#le level o+ sales !ithin the ne!
$arket"
4.3.4.5. 3ro%et plans
Atte$-ting to esta#lish o-erations in a ne! $arket $ay consu$e a
signi+icant -art o+ the #usiness ca-ital"
This a--lies to #oth s$all enter-rises an large cor-orations"
2or this reason, the entry atte$-t shoul #e care+ully -lanne an shoul
involve a etaile -ro9ect -lan"
This $ay inclue so$e o+ the +ollo!ing -oints"
5re-aration Ste-s involve #e+ore the $a9or e3-enses are
incurre" This $ay inclue researching the
$arket, esigning #roa -rouct s-eci+ications,
an conucting initial iscussions !ith -ossi#le
custo$ers an istri#utors"
Scheules A list o+ all the tasks to #e -er+or$e, along !ith
ti$e+ra$es, an cost allocations +or each ite$"
Scenarios A consieration o+ each -ossi#le outco$e, such as
lo!, $eiu$ or high sales e$an, an -lans +or
the course o+ action in each case"
Dithra!al A -lan to ter$inate the esta#lish$ent atte$-t
unless certain conitions arise, such as the
$ini$u$ sales volu$e #eing achieve !ithin a
011
certain -erio o+ ti$e, an !ithin the allocate
ca-ital cost"
Task etails 7escri-tions o+ each task, such as -rouct
evelo-$ent, avertising ca$-aigns, li$ite
iscount volu$es or ti$e -erios, an so on"
/osts %sti$ates o+ costs incluing irect e3-enses, the
cost o+ su#siies +or li$ite -erios, an costs
uner each scenario o+ sales"
4.3.4.!. /loating :s. fi)e( time .oriAons
In so$e cases, esta#lishing a -resence in a ne! $arket $ay involve a
consiera#le -erio o+ ti$e, an a large nu$#er o+ changes $ay occur uring
the -rocess o+ esta#lishing the o-eration"
5lans an irections $ay nee to #e change signi+icantly several ti$es
#e+ore a sustaina#le o-eration is +inally esta#lishe"
=o!ever, $aintaining a -ers-ective on the current situation $ay #e
i$-ortant in reucing the risk o+ a $a9or loss o+ ca-ital"
In so$e cases, a etaile -ro9ect -lan is create #e+ore an activity
co$$ences"
=o!ever, as ti$e -asses, #oth the costs o+ the activity an the ti$e -erios
involve $ay e3ten to levels that are +ar larger than the levels that !ere
inclue in the -ro9ect -lan"
The original -ro9ect -lan $ay #e +orgotten, an activities $ay continue on a
loss<$aking #asis until the #usiness ca-ital is consu$e"
Although -lans an irections $ay nee to #e aa-te as events un+ol,
re+erring #ack to an original +i3e -ro9ect -lan as a re+erence -oint $ay #e
use+ul in -reventing e3cessive losses occurring"
This $ay #e -articularly i$-ortant in co$ing to a ecision to ter$inate an
atte$-t at $arket entry, an to !ithra! +ro$ the activity"
A situation $ay so$eti$es evelo- in !hich each $onth activities continue
!ith the intention o+ ceasing atte$-ts in a short -erio o+ ti$e"
012
This situation can continue ine+initely, !ith a ecision never actually #eing
$ae to cease the loss<$aking activities"
Although the relevant issues in a #usiness ecision generally relate to +uture
-ossi#ilities, rather than -ast events, re+erring #ack to a -ast -oint o+
re+erence $ay #e essential in gaining a clear -ers-ective on the true nature o+
the current situation, an the nature o+ the a--roach that is currently #eing
taken"
This situation coul also #e escri#e as a +loating ti$e hori@on, rather than a
+i3e ti$e hori@on"
2or e3a$-le, an a--roach $ay #e taken that the esta#lish$ent atte$-t !ill
#e a#anone in t!o $onths ti$e i+ losses are still continuing"
=o!ever, a year later, the sa$e attitue $ay e3ist, !ith the a--roach #eing
that the atte$-t !ill #e a#anone in t!o $onthCs ti$e"
Situations such as this $ay #eco$e a -er$anent +eature o+ the #usiness
o-eration, an $ay rain cash +lo! +ro$ the #usiness an -revent the
#usiness +ro$ o-erating an evelo-ing e++ectively"
Dhen an a--roach such as this is taken, using iary entries an calenar<
#ase -lanning $ay #e use+ul in ensuring that, at a $ini$u$, the ecision is
care+ully revie!e !hen the -articular -oint in ti$e arrives, rather than #eing
a +loating target that is never reache"
Dithout re+erring #ack to a +i3e -oint o+ re+erence, activity $ay continue on
a -er$anent loss<$aking #asis, until the #usiness ca-ital is +inally consu$e"
4.3.4.7. 3reparation
The -re-aration stage involves a range o+ activities that coul occur #e+ore
the ecision !as $ae to -rocee !ith the -ro9ect, an #e+ore the $a9or
e3-enses are incurre"
This coul inclue so$e o+ the +ollo!ing activities"
Researching the $arket Researching $a9or co$-etitors, $argins
an volu$es !ithin the inustry, an the
ty-es o+ -roucts sol"
013
7iscussions /onucting -reli$inary iscussions !ith
custo$ers, su--liers an istri#utors, to
eter$ine the e$an +or ne! -roucts,
the likely $argins an cost structures,
an the likelihoo o+ the $arket #eing
close to ne! o-erations"
5rouct esigns 7evelo-ing #roa #asic -rouct esigns,
incluing costs, volu$es, an the ty-e
an escri-tion o+ the -roucts"
2acilities esign 5lanning the leasing, #uying or #uiling
o+ +acilities, an the costs an ti$e
involve in each situation"
4.3.4.8. +apital
A $arket entry atte$-t that !oul have a $a9or i$-act on the #usiness is
also likely to consu$e a signi+icant -ortion o+ the #usinessCs ca-ital"
A +i3e ca-ital allocation shoul #e $ae +or the esta#lish$ent atte$-t, !ith
the o-erations !ithra!n i+ a #reak<even sales level is not achieve !ithin
the #uget"
A stage -ro9ect $ay #e use to reuce the risk o+ a $a9or loss ue to a +aile
entry atte$-t"
This $ay involve a co$-lete $arket co$$ence$ent -ro9ect, #ase on a
s$all volu$e o+ sales"
This $ay involve a s$all +acility, o-erating !ithin a li$ite region"
I+ this +irst stage !as success+ul, then a larger -ro9ect coul #e conucte to
create larger +acilities to -rouce the +ull -lanne volu$e o+ -rouction"
This a--roach is kno!n as a :-ilot -ro9ect;, an is co$$on in $anu+acturing
o-erations, an in the evelo-$ent o+ ne! television series"
4.3.4.9. #enarios
Dhen the -ro9ect is i$-le$ente, a nu$#er o+ results $ay occur"
010
These $ay inclue
Blockages ue to govern$ent regulation"
Blockages ue to esta#lishe agree$ents #et!een su--liers an
custo$ers"
,o! sales volu$e"
Moerate sales volu$e"
=igh sales e$an"
%ach scenario shoul inclue a set o+ -lanne actions +ollo!ing this result"
All -ossi#le scenarios cannot #e consiere, as a !ie range o+ une3-ecte
events $ay occur"
=o!ever, so$e consieration o+ the -ossi#le actions that coul #e taken in
each situation $ay #e an i$-ortant -art o+ evelo-ing the -ro9ect -lan"
2or e3a$-le, although strong sales e$an !oul #e a -ositive outco$e, in
so$e cases this $ay lea to a +ailure o+ the $arket entry atte$-t"
This can occur !hen the #usiness cannot $eet the level o+ re&ueste sales,
long elays occur, an the -rouct looses +avour in the $arket"
The risk o+ this situation occurring coul #e reuce #y arranging stan<#y
te$-orary +acilities +or higher volu$e -rouction as -art o+ the -ro9ect -lan"
In $any cases this level o+ etail $ay #e e3cessive, ho!ever so$e early
consieration o+ the -ossi#ilities $ay a++ect the #roa +ra$e!ork o+ the
-ro9ect evelo-$ent"
4.3.4.1".-et.o(s of mar6et entr$
A nu$#er o+ a--roaches can #e taken to -roucing -roucts or services +or
sale !ithin a ne! $arket"
01*
These inclue evelo-ing ne! istri#ution channels an custo$er regions,
co$$encing o-erations using a start<u- a--roach, an #uying an e3isting
#usiness"
4.3.4.1".1. E)pan(ing (istribution
%3-aning istri#ution inclues evelo-ing ne! istri#ution channels, an
$arketing to a ne! region or grou- o+ -otential custo$ers"
This -rocess is generally suita#le +or graual entry to a ne! $arket, an is a
relatively lo!<cost alternative +or entering ne! $arkets"
7istri#ution channels coul involve thir<-arty istri#ution agree$ents !ith
other #usinesses, an su--lying -roucts to overseas i$-orters or $a9or retail
chains"
4.3.4.1".2. +ommening operations
/o$$encing o-erations is a si$ilar -rocess to a stanar #usiness start<u-
activity"
2or e3a$-le, a #akery $ay co$$ence o-erations in another region"
Si$-ly trans-orting the -roucts +ro$ the e3isting +acility !oul not #e a
-ractical alternative, as the goos !oul nee to #e -rouce at the -oint o+
sale"
%sta#lishing a ne! o-eration $ay involve leasing -re$ises, -urchasing
e&ui-$ent an stock, an co$$encing o-erations"
Si$ilar issues arise in service inustries, !here an overseas o-eration !oul
nee to have on<site sta++ to -er+or$ services +or clients"
/o$$encing o-erations is a lo!er<risk alternative than a start<u- o-eration
o+ a co$-letely ne! #usiness"

Also, no accounting goo!ill cost is involve, !hich $ay occur in the case
o+ -urchasing an e3isting #usiness"
=o!ever, a signi+icant ca-ital cost $ay #e involve, an sales volu$es $ay
not evelo- +or a -erio o+ ti$e"
01)
This a--roach is -articularly suita#le +or #usinesses that service a li$ite
region aroun the #usiness o-eration"
4.3.4.1".3. Bu$ing a business
Buying another #usiness is a co$$on +or$ o+ $arket entry in the case o+
large enter-rises"
%ntry to a ne! $arket is one o+ the $ost co$$on reasons that large
#usinesses are -urchase"
A isavantage !ith this $etho is that a goo!ill cost $ay #e involve"
This is the aitional cost re&uire to -urchase the #usiness, a#ove the value
o+ the net assets"
=o!ever, this $etho has a nu$#er o+ avantages"
Sales volu$e occurs i$$eiately, an this is a lo!<risk a--roach to
co$$encing o-erations in a ne! $arket"
Also, -ro#le$s !ith close $arkets o not a--ly"
This is -articularly relevant to licences, !here a s$all nu$#er o+ availa#le
licences to o-erate $ay #e tightly hel #y several organisations"
Television #roacasting is an e3a$-le o+ this"
%ntry to the television #roacasting inustry is only -ossi#le at a -ractical
level though #uying an e3isting #roacaster"
The issue o+ close $arkets also arises !hen the links #et!een su--liers an
custo$ers are tie u- in long<ter$ agree$ents"
This a--roach $ay also #e relevant to inustries that o-erate !ith signi+icant
econo$ies o+ scale, !here the inustry $ay #e consoliate into a +e! large
organisations"
In these situations, co$$encing a s$all o-eration an graually e3-aning
$ay not #e a -ractical alternative"
018
In this case, either #uying an e3isting #usiness, or a large start<u- activity
involving constructing high<ca-acity +acilities $ay #e neee to co$$ence
o-erations !ithin the ne! $arket"
Ance a #usiness has #een -urchase, several alternatives are availa#le"
These $ay inclueE
Maintaining the #usiness as an ine-enent o-eration"
Integrating the #usiness !ith e3isting o-erations"
/onucting a -artial integration, to achieve econo$ies o+ scale !ith
services such as co$-uter +acilities"
Hsing the ne! #usiness as a istri#ution channel +or the #usinessCs
-roucts"
4.3.4.1".4. Te.nolog$ & innovation
There can #e signi+icant inertia involve in changes to #usiness o-erations"
/o$$encing -urchases +ro$ a ne! su--lier, +or e3a$-le, $ay involve
setting u- accounts, negotiating contracts, esta#lishing regular -roceures,
an so on"
2or this reason, custo$ers !oul nor$ally not change +ro$ an esta#lishe
su--lier to a ne! su--lier that o++ere the sa$e -roucts at the sa$e -rices
as the e3isting su--lier"
Also, $any inustries are highly co$-etitive, an -rices settle at the lo!est
sustaina#le level"
In these cases, it $ay #e very i++icult +or a ne! #usiness to o++er -roucts at
su#stantially lo!er -rices than e3isting su--liers"
Ane solution to this -ro#le$ $ay involve the use o+ technology an -rouct
innovation"
This $ay involve evelo-ing ne! technology in<house, or licensing
technology +ro$ another #usiness"
011
This secon situation -articularly a--lies to technology that is use in
another region #ut is not currently use !ithin the region that is service #y
the #usiness"
Technology coul inclue co$-uter syste$s +or $anaging -rouction,
$anu+acturing -rocesses that allo! a -rouct to #e create $ore e++iciently,
an -atente syste$s that can #e inclue as -art o+ the -rouct itsel+"
5rouct innovation is a relate issue"
Although there can #e consiera#le inertia in changing #usiness
arrange$ents, there can also #e consiera#le inertia in u-ating -rouct
esigns"
In $any cases the -roucts that are sol !ithin an inustry $ay have
change little +or $any years, or in so$e cases +or ecaes"
In other cases, $any changes $ay have #een $ae, ho!ever the esigns $ay
still #e #ase on a structure +ro$ the istant -ast that is not really suita#le +or
the current uses o+ the -roucts"
This situation $ay -rovie a #usiness !ith the o--ortunity to evelo- ne!
an innovative -roucts that $ay attract interest +ro$ custo$ers"
4.3.4.1".5. 3ur.asing a liene
In so$e inustries, a licence is re&uire #e+ore a #usiness can o-erate !ithin
the inustry"
The cost o+ the licence #eco$es a ca-ital cost re&uire to co$$ence
o-erations !ithin the inustry"
,icences +all into t!o categories"
The nu$#er o+ licences $ay #e restricte, or it $ay #e unrestricte"
In the case o+ unrestricte licences, the #usiness $ust $eet certain criteria
#e+ore it $ay o-erate !ithin the inustry"
Banking is an e3a$-le o+ this"
016
There is generally no restriction -lace on the nu$#er o+ #anks that $ay
o-erate !ithin an econo$y"
=o!ever, a #anking licence $ust #e issue #y the central #ank #e+ore a
#usiness is -er$itte to -er+or$ #anking services"
S-eci+ically, this relates to acce-ting e-osits +ro$ the general -u#lic"
Any #usiness can generally o++er loans, as in this case the risk lies !ith the
#usiness, not the custo$er"
A #usiness $ust $eet certain re&uire$ents #e+ore a #anking licence !ill #e
grante, such as a $ini$u$ level o+ shareholerCs ca-ital to act as a #u++er
against #a e#ts, an segregation o+ the #anking activities +ro$ other
#usiness activities"
Restricte licenses $ay #e ue to -hysical restrictions, such as the allocation
o+ raio +re&uencies +or #roacasting, or the ter$inals at a sea -ort or air-ort"
In other cases a li$ite nu$#er o+ licences $ay #e issue +or other reasons,
such as li$iting the nu$#er o+ +acilities that $ay #e create"
Ta3i licences are so$eti$es restricte in this !ay"
,icences create a #arrier to entry"
This $ay -resent a signi+icant -ro#le$ to a #usiness that !ishes to esta#lish
o-erations !ithin a ne! inustry"
Dithin these inustries, -urchasing a licence to o-erate $ay #e a $a9or
$etho o+ $arket entry, an in +act $ay #e a re&uire$ent o+ co$$encing
o-erations"
In cases !here a large nu$#er o+ licences are issue, an active $arket in
#uying an selling licences !ill generally e3ist"
In the case o+ a s$all nu$#er o+ licences, in -ractice another #usiness $ay
nee to #e -urchase in orer to gain a licence to o-erate !ithin the inustry"
,icences also create a #arrier to e3it"
A #usiness cannot generally $ove graually into another inustry !hen
-ro+ita#ility levels +all !ithin a license inustry"
020
In general a $a9or #usiness change $ust #e $ae to enter or e3it an inustry
in these cases"
In -ractice, -ro+ita#ility !ithin close inustries i+ o+ten lo!, an it is not
unco$$on +or a #usiness to #eco$e insolvent an to cease o-erations !ithin
an inustry that has restricte licenses"
This is ue to the +act that the e3isting #usinesses !ithin the inustry have no
o-tion +or e3-ansion, other than increasing $arket share +ro$ the other
#usinesses !ithin the inustry"
4.3.4.11. Establis.ment approa.es
4.3.4.11.1. '(vertising & 3romotion ampaigns
In $arkets that involve sales to the general -u#lic, avertising an
-ro$otional ca$-aigns $ay #e use"
This coul inclue avertise$ents on television, raio, #ill#oars, an !ithin
$aga@ines or ne!s-a-ers"
Avertising can #e e3-ensive, an in general the avertising e++ort shoul #e
concentrate to !ithin a s$all enough region to have a -ractical i$-act,
!hile also covering a large enough region to generate sales volu$es"
5ro$otion ca$-aigns $ay inclue -roviing +ree sa$-les an
e$onstrations, istri#uting $arketing $aterial an -rouct in+or$ation, an
a--earing at events such as activities that are relate to the ty-e o+ -rouct
#eing -ro$ote"
Most tasks involve in a -ro9ect launch are eter$ine in avance, an the
cost is then eter$ine +or each ite$"
2or e3a$-le, +acilities $ay have to #e #uilt, lease or -urchase to ena#le the
-rouct to #e $anu+acture in the -lanne volu$es"
=o!ever, in the case o+ avertising an -ro$otion, the o--osite situation
a--lies"
In these cases, an ar#itrary a$ount is allocate +or this -ur-ose, an then the
+uns are s-ent in the $ost e++ective !ay +or the -articular ty-e o+ -rouct"
021
2or e3a$-le, the #usiness $ay eter$ine the total +i3e costs, an then
ecie to allocate an e&ual a$ount +or avertising an -ro$otion, to
eter$ine the total cost o+ the -ro9ect"
Avertising is e3-ensive"
,arge -rouct launches $ay involve $any $illions o+ ollars in avertising
costs"
In the case o+ s$all enter-rises, avertising $ay also #e a signi+icant
e3-ense, an the avertising #uget generally nees to #e s-ent in the $ost
e++ective !ay in orer to generate sales o+ the #usinessCs -roucts or services"
4.3.4.11.2. 8oss lea(ers
A loss leaer is a -rouct that is sol +or #elo! the cost o+ -rouction"
The ai$ in this case is to esta#lish a $arket -resence an -ossi#ly an e3isting
client #ase, !hich $ay then +lo! through to a sustaina#le level o+ sales"
The loss incurre on the sale o+ the ite$s !oul #e allocate as a cost !ithin
the -ro9ect #uget"
This can #e a signi+icant e3-ense"
In so$e co$-etitive $arkets, #usinesses s-en a signi+icant -ortion o+ their
ca-ital on selling -roucts at #elo! cost, in atte$-ts to esta#lish a sustaina#le
$arket -osition"
4.3.4.11.3. Diret ontrat
In cases !here a -rouct or service is sol to a s$all nu$#er o+ custo$ers,
irect contact +ro$ the #usiness $ay #e use"
This $ay involve re&uesting an o--ortunity to conuct a -resentation, an
-rovie sa$-le -roucts an -rouct in+or$ation"
Initial su--lies $ay occur on a trial #asis, !ith larger sales volu$es
occurring as ti$e !hen #y"
022
4.3.5. '(vertising an( bran( profile
Avertising can #e use to -ro$ote -roucts, services, an s-eci+ic events
such as a li$ite iscount -erio"
Avertising can also #e use in raising the general -ro+ile o+ #ran na$es"
2or e3a$-le, /oca /ola is argua#ly the $ost +a$ous #ran na$e in the
!orl"
The #ran na$e o+ /oke has #een value in the #illion ollar range (>>
check +igures)"
This is si$-ly the value that is -lace on the -u#lic -ro+ile o+ the #ran, it
oes not involve any assets or -rouction o+ the co$-any"
2or e3a$-le, /oke is very !ell kno!n, an i+ this #ran is -lace on a shel+
#esie a si$ilar -lain la#el cola #ran, a $uch larger volu$e o+ /oke !oul
#e -urchase than the si$ilar -lain la#el #ran"
The -ro+ile o+ /oke is $aintaine through constant high<-ro+ile avertising"
Shoul this avertising cease, it !oul #e likely that /oke !oul graually
+all +ro$ +avour over a -erio o+ $any years"
So$e #ran na$es have a li$ite li+e s-an an their -ro+ile e3-ires a+ter a
-erio o+ ti$e"
Although they are not #ran na$es, the -ro+ile o+ +il$ an $usic releases
+alls into this category"
In other cases, a #ran na$e $ay #e $aintaine ine+initely through
continuous avertising an -ro$otion"
=o!ever, accoring to so$e schools o+ thought, a #ran na$e cannot #e
resurrecte once it has la-se an +allen +ro$ +avour"
Bran -ro+ile is a signi+icant issue in co$$oity -roucts that are -urchase
#y the general -u#lic"
This inclues -roucts an services !hich occur in large volu$es, an !here
a range o+ si$ilar ite$s are availa#le +ro$ i++erent su--liers"
Banking is an e3a$-le o+ this situation"
023
In $any cases, #anking services o not vary greatly +ro$ one #ank to
another, an the #ran -ro+ile o+ a #ank is a signi+icant issue in attracting an
retaining custo$ers"
In contrast, #ran na$es $ay not #e a signi+icant issue in !holesale $arkets,
an in large scale transactions"

4.3.!. Target -ar6ets
A target $arket involves a grou- o+ custo$ers that are likely to -urchase a
-rouct"
This $ay #e an issue in esigning an evelo-ing a -rouct, an also in
$arketing an istri#ution"
2or e3a$-le, retire$ent inco$e -roucts !oul only #e -urchase #y
retirees, !hile teenage +ashion !oul only #e -urchase #y teenagers"
2ar$ e&ui-$ent !oul only #e -urchase in rural areas, an there !oul #e
little -oint in avertising +ar$ e&ui-$ent in ur#an areas"
Target $arketing involves irecting the $arketing e++orts to!ars the grou-
o+ -otential custo$ers that are $ost likely to -urchase the -rouct"
Ienti+ying this grou- is the +irst ste- in the -rocess"
In so$e cases the target $arket $ay #e o#vious, as in the -revious e3a$-les"
In other cases, revie!ing the current custo$er -ro+ile $ay -rouce sur-rising
results, !ith the custo$ers !ho are actually -urchasing the -rouct #eing
&uite i++erent +ro$ the custo$ers that the -rouct !as esigne +or, or the
custo$ers that $ay have #een e3-ecte"
Ane a--roach is to revie! the in+or$ation availa#le a#out e3isting
custo$ers"
2or e3a$-le, in the case o+ on<going services, a consiera#le a$ount o+
in+or$ation $ay #e store a#out each custo$er"
In other cases, little in+or$ation $ay #e availa#le"
020
In the case o+ cash sales at retail outlets, +or e3a$-le, little $ay #e kno!n
a#out the custo$er -ro+ile"
In these cases, surveys o+ a rano$ sa$-le o+ custo$ers $ay #e conucte"
In other cases, sa$-les o+ a -otential ne! -rouct $ay #e create an
surveys o+ the general -u#lic coul #e conucte"
Market research agencies organise an conuct research a#out custo$er
-erce-tions o+ e3isting -roucts, -roucts !ithin certain categories, an
reactions to sa$-les o+ -otential ne! -roucts"
A target $arket $ay #e ienti+ie as -art o+ the -rouct esign an #usiness
evelo-$ent strategy, or it $ay #e ienti+ie +ro$ the -ro+ile o+ e3isting
custo$ers"
=aving ienti+ie the target $arket, -ro$otion can then targete in that
irection"
This $ay involve avertising in certain $aga@ines or television -rogra$s,
arranging links !ith various associations, an arranging thir<-arty
istri#ution agree$ents !ith #usinesses that -rovie services to a si$ilar
range o+ -eo-le"
Market research agencies $aintain $ailing lists o+ -otential custo$ers #ase
on a !ie range o+ i++erent -ro+iles"
4.3.7. Ten(ers
In so$e #usiness o-erations, a s$all nu$#er o+ large transactions are
involve"
This occurs, +or e3a$-le, in co$$ercial construction, contract services, an
co$-uter so+t!are evelo-$ent"
In these situations, selecting a su--lier #y tener is a co$$on arrange$ent"
Selecting -arties $y tener is use in the +ollo!ing circu$stances"
5ro9ect evelo-$ents, such as construction"
Service contracts, such as $aintenance or a$inistration services"
02*
Su--ly contracts, incluing regular su--lies o+ co$$oities such as
ra! $aterials or $achinery -arts"
The sale o+ large assets, incluing #usinesses, -ro-erties, an
in+rastructure such as air-orts"
Teners $ay #e invite +or continuous arrange$ents, such as contract
services, or +or s-eci+ic -ro9ects, such as a co$$ercial #uiling construction"
This -rocess #egins !ith the custo$er -osting an announce$ent that teners
are invite to co$-lete a -ro9ect or -rovie a service"
Businesses coul then su#$it a re&uest +or in+or$ation, !hich !oul
generally involve etaile in+or$ation #eing su--lie #y the custo$er"
This $ay inclue so$e o+ the +ollo!ing in+or$ation"
A escri-tion o+ the -ro9ect or service"
Basic s-eci+ications an ti$e +ra$es"
Re&uire$ents such as volu$es o+ su--ly"
5ossi#ly a range o+ e3-ecte -rices as an inication o+ the level o+
service that !as re&ueste +or su#$itte teners"
In so$e cases tener in+or$ation $ay #e highly etaile, an $ay e++ectively
+or$ one<hal+ o+ the -otential contract !ith the evelo-er or su--lier"
In other cases, the tener in+or$ation $ay #roaly outline a -ro9ect, !ith the
etaile negotiations an -ro9ect esign to #e conucte at a later ate"
A+ter revie!ing the tener in+or$ation, the #usiness $ay then -re-are a
su#$ission"
So$e o+ the etails that $ay #e inclue in a tener su#$ission coul
inclue the +ollo!ing
7etails o+ +ees charge +or each service or each stage o+ the -ro9ect"
7etails o+ -ay$ent arrange$ents, such as -rogress -ay$ents"
02)
5oints that !ere s-eci+ie in the tener re&uest that are not inclue
as -art o+ the -ro-osal"
Aitional services o++ere !ith the su#$ission"
5ro-ose ti$e +ra$es +or the -ro9ect, i+ this !as not s-eci+ie in the
original s-eci+ication"
In+or$ation su--orting the #usinessCs a#ility to co$-lete the
-ro9ect, such as ca-ital #acking, e&ui-$ent an sta++ arrange$ents"
In+or$ation su--orting the #usinessCs a#ility to co$-lete the -ro9ect
accoring to the scheule, !ithin #uget an to &uality stanars,
such as client or ine-enent revie!s o+ -revious -ro9ects"
In the case o+ co$-le3 evelo-$ent -ro9ects, several $onths !ork coul #e
involve in -re-aring a tener su#$ission"
A $a9or issue in selecting a tener $ay #e the strength o+ the case su--orting
the #usinessCs a#ility to co$-lete the -ro9ect e++ectively"
5rice oes not #eco$e relevant until a+ter the case has #een esta#lishe that
the #usiness has the ca-acity to e++ectively co$-lete the -ro9ect or su--ly the
-roucts"
A short<list o+ teners $ay #e create, #ase on the su#$issions that o++er to
co$-lete the -ro9ect accoring to s-eci+ication, an !here the tenering
#usiness a--ears likely to co$-lete the -ro9ect i+ the tener is selecte"
A+ter the short list has #een selecte, -rice $ay #eco$e a $a9or issue"
In the case o+ stanarise -roucts an services, -rice $ay #eco$e the
$a9or +actor"
2or e3a$-le, this coul inclue so$e o+ the +ollo!ingE
Scheule $aintenance accoring to $anu+acturerCs s-eci+ications"
/o$$oity -roucts such as agricultural -roucts o+ s-eci+ie
graes, $achinery -arts, co$-uter har!are evices an so on"
In other cases, -rice $ay #e less signi+icant, an the +ull range o+ in+or$ation
!ithin a tener su#$ission $ay #e relevant to the +inal ecision"
028
This $ay -articularly occur !hen the -ro9ect involves consiera#le risk, an
the a#ility o+ the #usiness to co$-lete the -ro9ect e++ectively $ay #e
signi+icant"
Also, -rice $ay #e o+ less irect signi+icance in large an co$-le3 -ro9ects,
an in service contracts involving tasks such as -ro9ect $anage$ent, !here
the service o++ere $ay i++er signi+icantly +ro$ one #usiness to another"
Tenering is a co$-etitive -rocess, an a care+ul consieration o+ the likely
su#$issions o+ other -arties $ay #e necessary in orer to select -ricing
levels, highlight strengths, an aress !eaknesses in the -ro-osal through
actions such as arranging +acilities +ro$ other su--liers that the #usiness is
not a#le to su--ly irectly"
4.3.8. 3ro(ut proposals
5ro-osals to -otential clients $ay +ollo! a si$ilar -attern to tener
su#$issions, on a s$aller scale"
A !ritten -ro-osal su#$itte to a -otential client $ay inclue so$e o+ the
+ollo!ing in+or$ationE
A escri-tion o+ the -rouct"
Technical etails an s-eci+ications"
Basic in+or$ation a#out the #usiness"
7etails o+ the #usinessCs a#ility to su--ly the -rouct in su++icient
volu$es on a relia#le #asis"
5er+or$ance etails o+ the -rouct"
5ricing etails"
A -resentation co$#ining a !ritten su#$ission !ith a ver#al -resentation
$ay #e $ore success+ul than si$-ly su#$itting a !ritten -ro-osal"
This $ay -articularly a--ly !hen the -ro-osal is initiate #y the #usiness,
rather than #eing a res-onse to a re&uest +or in+or$ation +ro$ a -otential
custo$er"
021
In $any cases, !ritten -ro-osals that are su#$itte +or consieration $ay
never #e rea"
4.3.9. -ar6eting material
Marketing $aterial can inclue #rochures, etaile -rouct guies, !ritten
technical in+or$ation, an vieo -resentations"
In situations !here a s$all nu$#er o+ clients or custo$ers !ere involve,
$arketing in+or$ation $ay also #e !ritten s-eci+ically +or the client"
In these cases, a set o+ stanar in+or$ation $ay #e -rouce a#out the
-rouct, incluing a escri-tion o+ the -rouct, s-eci+ications, an
-er+or$ance results"
Su#$issions to a -otential client $ay inclue the stanar $arketing
$aterial, together !ith in+or$ation on -ricing, volu$es, recent in+or$ation,
an custo$isation o+ the -rouct to suit the -articular client"
In the case o+ retail istri#ution to the general -u#lic, $arketing $aterial $ay
#e istri#ute through retail outlets, #y irect $ail, an through other
#usinesses uner a thir<-arty istri#ution arrange$ent"
Dhen a thir<-arty istri#ution arrange$ent is use, su--orting $arketing
$aterial such as #rochures is generally su--lie #y the #usiness as -art o+ the
istri#ution arrange$ent"
4.3.1". +ustomer pereptions & preferenes
The i$-ortance o+ custo$er -erce-tions can #e illustrate using the story o+
:clouy a$$onia;
A$$onia is istri#ute in a ilute #ottle +or$ +or use as a househol
isin+ectant"
5rouction o+ househol a$$onia in the istant -ast involve a -rocess that
-rouce a -rouct that containe a nu$#er o+ i$-urities"
These i$-urities gave the -rouct a $ilky a--earance, even through
a$$onia itsel+ is clear"
026
4e! $anu+acturing -rocesses !here evelo-e that resulte in a higher
&uality -rouct !ith less i$-urities"
=o!ever, the ne! -rouct !as clear o+ i$-urities an !as trans-arent in a
si$ilar !ay to #ottle !ater"
Sales o+ the ne! -rouct !ere lo!, as consu$ers assu$e that the ne!
-rouct !as less concentrate, ue to its less $ilky a--earance"
This -ro#le$ !as eventually aresse #y aing arti+icial i$-urities to the
li&ui, to give it a $ilky a--earance"
This -rouct is kno!n as :clouy a$$onia;"
This situation evelo-e in the 1620Cs (>>check ecae), an :clouy
a$$onia; is still sol toay #y a nu$#er o+ i++erent $anu+acturers"
There are several lessons +ro$ this story +or the $arketing o-erations o+ a
#usiness"
2irst, the a--earance o+ a -rouct is 9ust as i$-ortant as its su#stance or
+unctions"
So$e -roucts have the $ost unlikely a--earance #ut #eco$e legenary +or
a -articular +unction"
=o!ever, this is rare, an in the reality o+ general #usiness o-erations, the
a--earance an custo$er -erce-tions o+ a -rouct $ay have a large i$-act
on sales"
Also, a -rouct or service that is i++erent +ro$ e3isting ite$s $ay have slo!
sales initially, until custo$ers #eco$e a!are o+ the #ene+its o+ the -rouct or
service"
4.3.11. -ar6eting 'pproa.es
4.3.11.1. -ultiple bran( names
Many #usinesses o++er several se-arate #rans"
These $ay #e co$-letely ine-enent activities, !hich each #ran having
se-arate -roucts, cost structures an $arketing activities"
030
In other cases, a -rouct is re<-ackage uner se-arate #ran na$es an a
single -rouct is sol uner $ulti-le #rans"
There $ay #e several -otential #ene+its !ith o++ering $ulti-le #rans"
Specific customer groups
In so$e cases, #rans an -rouct lines are ai$e at a -articular consu$er
grou-, such as a -articular age range"
Maintaining several se-arate #rans $ay allo! a #usiness to o-erate
activities !ithin several se-arate $arkets"
Internal costs, such as $anu+acturing +acilities, coul then #e s-rea across a
larger nu$#er o+ ite$s, resulting in lo!er costs -er unit"
-arget market demand
In so$e cases, there $ay #e istinct $arket e$ans +or i++erent levels o+
service or -rouct +eatures"
Multi-le #rans are so$eti$es use in these cases"
2or e3a$-le, a stock#roking o-eration $ay o++er a +ull service o-eration that
inclue invest$ent avice, an also o++er a lo!er cost service uner a
se-arate #ran that only -rovie irect traing +acilities"
Brand names s! Production
In $any cases, there $ay #e a se-aration #et!een the #ran na$e an
$arketing activities, an the $anu+acturing -rocess"
A #usiness $ay o!n #ran na$es #ut not $anu+acturing +acilities"
In this case, an e3ternal $anu+acturer $ay #e use to -rouce the -roucts
on a contract #asis, #ase on stanar -roucts, or esigns su--lie #y the
#usiness"
In other cases a #usiness $ay o-erate $anu+acturing +acilities on a !holesale
#asis #ut not o!n #ran na$es"
031
This $ay involve selling stanar -roucts in !holesale $arkets, or
-er+or$ing contract $anu+acturing +or other #usinesses"
In so$e cases, a #usiness $ay o-erate $anu+acturing +acilities in<house, an
also $anage #ran na$es an conuct $arketing activities"
Canni"alisation of sales
A isavantage o+ $ulti-le #ran na$es $ay involve the risk o+
canni#alisation o+ e3isting sales"
This can occur !hen a ne! lo!<cost service is esta#lishe, an sales +ro$
e3isting services are lost to the ne! service, resulting in a reuction in -ro+it
rather than an increase"
/anni#alisation is a -otential -ro#le$ +or e3isting #usiness esta#lishing a
lo!<cost iscount -rouct or services"
=o!ever, the ne! -roucts an the e3isting -roucts can each #e vie!e as
ine-enent $arkets"
4e! -roucts are usually o++ere !hen there is a $arket e$an +or the
-rouct or service, an co$-eting #usinesses $ay also #e o++ering a -rouct
or service o+ a si$ilar ty-e"
In these cases, a certain -ro-ortion o+ custo$ers !ill #e lost in any event,
either to the ne! o-eration, or to si$ilar o-erations o+ co$-eting #usinesses"
/anni#alisation $ay #e a signi+icant issue in -reventing ne! -roucts +ro$
#eing launche #y large organisations"
Sales o+ the ne! -rouct $ay reuce sales o+ e3isting -roucts, an this $ay
lea to the ne! -rouct +ailing to #e launche"
=o!ever, each o+ these areas $ay #est #e vie!e ine-enently"
I+ a #usiness +ails to launch a -otentially success+ul -rouct or service ue to
the e++ect that it $ay have on other -roucts, this $ay har$ the #usiness
overall"
%ach -rouct shoul rise or +all on its o!n $erits"
Any atte$-t to arti+icially alter this #y irect intervention, $ay result in a
cost to the #usiness, rather than a #ene+it"
032

4.3.11.2. -ultiple versions
Multi-le versions o+ -roucts can #e o++ere in situations !here the -rouct
is an a#stract esign"
This $ay inclue o++ering #asic versions o+ the -rouct at lo!er -rices than
the +ull version, or altere versions o+ the -rouct +or s-eci+ic -ur-oses"
This $ay ena#le a larger nu$#er o+ ite$s o+ the -rouct itsel+ to #e sol, #y
o++ering the -rouct in i++erent seg$ents o+ the $arket"
2il$s are one e3a$-le"
A co$-lete +il$ coul #e istri#ute as it stoo"
Also, su#titles or voice u##ing coul #e ae to allo! the +il$ to #e
istri#ute in +oreign countries, !here i++erent languages !ere use"
Sections o+ the +il$ coul also #e use in $usic vieo cli-s, +or avertising
-ur-oses an so on"
In other cases, a #asic esign is aa-te into several i++erent ty-es o+
-rouct"
2or e3a$-le, a co$-lete structural esign o+ a ne! car $ay #e aa-te +or 2<
oor, 0<oor an converti#le versions"
In $any cases, a large ca-ital cost is involve in evelo-ing a esign, an
these alternatives $ay allo! a larger nu$#er o+ sales to #e generate +ro$
the results o+ the evelo-$ent"
4.3.12. -ar6et & +ompetitor anal$sis
A #usiness shoul generally #e a!are o+ custo$ersC interests in -roucts, an
#e a!are o+ the -roucts an o-erations o+ co$-etitors"
This -articularly a--lies !ithin +ashion<conscious inustries"
/lothing is one o#vious e3a$-le"
033
=o!ever, +ashion also a--lies in $usic, +il$, an a range o+ inustries that
are traitionally consiere to #e serious or conservative"
In $any cases, certain ty-es o+ -roucts $ay #eco$e +ashiona#le or
un+ashiona#le +ro$ ti$e to ti$e, resulting in large sales o+ +ashiona#le
-roucts an +e! sales o+ un-o-ular -roucts"
5u#lic co$-anies -u#lish annual re-orts an auite +inancial state$ents,
!hich are loge !ith govern$ent regulators, stock e3changes, an issue to
the general -u#lic"
Although this in+or$ation a--ears in a su$$ary +or$at, #asic etails such as
$argins can #e calculate"
Also, averages !ithin inustries +or +igures such as $argins an e-reciation
rates are co$-ile an -u#lishe #y various -arties such as stock e3changes
an govern$ent e-art$ents"
/o$-aring the #usinessCs +igures against other +igures $ay highlight
-otential -ro#le$s"
2or e3a$-le, i+ $argins are lo!er than ty-ical inustry levels, then the
#usiness $ay #e e3-eriencing o-erational -ro#le$s, an attention $ay nee
to #e +ocuse in this area"
/onversely, i+ $argins are soli, o-erations $ay #e e++ective, an e++orts
$ay #e concentrate on -rouct evelo-$ent an $arketing activities"
Inustry $argins are -articularly relevant in the case o+ start<u- o-erations"
In this situation, inustry $argins can #e use as an in-ut into -lanning the
+inancial structure o+ the #usiness, an esti$ating +igures such as the ca-ital
re&uire, the e3-ecte -erio o+ negative cash +lo!, sale -rices an so on"
=o!ever, e3cessive +ocus on either custo$erCs interests or co$-etitorCs
activities shoul generally #e avoie"
/usto$ers $ay re&uest certain ty-es o+ -rouct, an yet !hen the -rouct is
-rouce, sales $ay #e slo!"
Also, ne! ieas an -roucts $ust generally co$e +ro$ !ithin the #usiness
an #e -resente to -otential custo$ers"
030
%3cessive +ocus on custo$ers $ay -revent the #usiness +ro$ evelo-ing ne!
an ine-enent ieas, that $ay $eet !ith sur-rise #ut high levels o+ interest
+ro$ -otential custo$ers"
Also, although a general a!areness o+ co$-etitorCs -roucts an o-erations
$ay #e use+ul in eter$ining +uture irections o+ the #usiness, a #usiness
shoul generally avoi $aking ecisions s-eci+ically #ase on co$-etitorCs
actions"
Dhen this occurs, a cycle o+ action an reaction $ay occur, !ith ecisions
#eing $ae on the #asis o+ a co$-etitorCs latest action, rather than the
general evelo-$ent o+ the #usiness"
A -rice !ar is an e3a$-le o+ this situation"
In a -rice !ar, one $a9or #usiness lo!ers -rices in orer to increase $arket
share"
/o$-etitors $ay then res-on #y also reucing -rices, an a sustaine
-erio o+ lo!er -ro+ita#ility +ollo!s, !ith a trans+er o+ value +ro$ the entire
inustry to the custo$er occurring"
Also, co$-aring the #usiness to co$-etitors $ay create a range o+
unconscious structures an #ench$arks that $ay li$it the a#ility o+ the
#usiness to evelo- an evolve in e++ective irections"
Business is a co$-etitive activity, an in so$e situations irect co$-etition
!ith other #usinesses occurs"
Su#$itting teners +or -ro9ects an service contracts is an e3a$-le o+ a
co$-etitive situation"
=o!ever, $any success+ul -roucts an #usinesses are erive +ro$
co$-letely ignoring custo$ers an co$-etitors, an evelo-e -roucts an
#usiness structures that are e++ective in their o!n right"
Dhen this is one, strong sales $ay occur an the #usiness $ay evelo-
success+ully, regarless o+ the i++erent -aths taken #y various co$-etitors"
As a general rule, ecisions $ay #e $ae consiering the +ollo!ing three
issues, in escening orer o+ -riority"
1" The nature o+ the -rouct an the #usiness itsel+"
03*
2" The interests an e$ans o+ custo$ers"
3" The actions an -roucts o+ co$-etitors"
".". 3ro(uct (esign & (evelopment
5rouct esign $ay involve issues relate to the actual esign o+ an ite$ or
service, in aition to issues such as -ricing o+ the -rouct, the target $arket,
an the $ethos use +or -roucing an istri#uting the -rouct"
4.4.1. 3.$sial (esign
In the case o+ $anu+acturing, an engineering esign -rocess $ay #e involve
in creating the -hysical esign o+ a ne! -rouct"
This $ay range +ro$ a s$all activity that $ay #e co$-lete in a short -erio
o+ ti$e, u- to -rouct esign -ro9ects such as the esign o+ a large ne!
aircra+t"
In this secon case, the esign -rocess $ay continue +or a ecae, an
involve large su$s o+ ca-ital, thousans o+ hours o+ testing an co$-le3
co$-uter si$ulations"
The -hysical esign $ay consier the costs an -ro-erties o+ i++erent
$aterials, the stresses !ithin the -hysical structure, an tolerances to
-ressure, te$-erature an so on"
The esign -rocess $ay involve esigning a structure #ase on engineering
calculations, !ith the ai o+ co$-uter -rocessing to -er+or$ calculations an
is-lay ra+t esigns"
5hysical $oels an co$-uter si$ulations $ay then #e use to test the
-er+or$ance o+ the -rouct uner i++erent -hysical conitions"
In so$e cases, a large a$ount o+ testing an evelo-$ent o+ -rototy-es $ay
also #e involve"
In aition to the engineering esign, so$e -roucts have a gra-hic esign
co$-onent +or their -hysical +or$, structure an a--earance"
03)
The gra-hic esign $ay also -ass through $any stages #e+ore a +inal esign
is chosen"
4.4.1.1. 3rotot$pes
Moels an -rototy-es $ay #e evelo-e +or e$onstration to -otential
custo$ers, an +or testing -ur-oses"
2or e3a$-le, !in<tunnel testing o+ -rototy-e aircra+t $ay #e conucte,
!hile a !ie range o+ testing $ay #e -er+or$e on -rototy-es o+ various
-roucts"
4.4.1.2. #imulations
%ngineering an construction esign $ay use co$-uter $oelling an
si$ulations in the esign -rocess"
This $ay inclue co$-uter aie ra+ting an esign syste$s, !hich $ay
ena#le architectural an construction engineering -lans to #e esigne an
recore"
In the case o+ si$ulations, the -er+or$ance o+ -roucts in various -hysical
conitions, an the internal o-erations an e++iciency o+ -roucts $ay #e
si$ulate using co$-uter $oels an -rocesses"
4.4.1.3. +ontat engineering
5hysical esign o+ -roucts $ay #e -re+or$e internally #y the #usiness"
Alternatively, contract engineering services $ay #e use to co$-lete -arts o+
the esign -rocess, or to -rouce a co$-lete esign accoring to
re&uire$ents that !ere s-eci+ie #y the #usiness"
038
4.4.1.4. +omple)it$? osts & reliabilit$
The co$-le3ity o+ a -hysical -rouct esign $ay have a consiera#le i$-act
on the cost o+ -rouction, the -er+or$ance o+ the -rouct, an the relia#ility
o+ the -rouct o-eration"
A si$-le -rouct esign $ay have so$e o+ the +ollo!ing #ene+its in
co$-arison to a -rouct esign that $ay involve $any -arts an co$-le3
o-erations"
More relia#le o-eration"
,o!er costs +or $aterials, -rouction +acilities, an -rouction
e3-enses"
The a#ility to -rouce a larger nu$#er o+ ite$s !ithin a -erio o+
ti$e +ro$ a -rouction +acility"
In so$e cases, a -rouct that $ay have high -er+or$ance an allo! e++icient
o-eration $ay involve a co$-le3 esign"
=o!ever, all else #eing e&ual, a si$-le esign $ay have a range o+ #ene+its
in co$-arison to a -rouct that is -oorly esigne through using a large
nu$#er o+ -arts to -er+or$ +unctions that coul #e -er+or$e using a $uch
si$-ler esign"
A large co$-onent o+ a esign -rocess $ay involve reucing a range o+
co$-le3 +unctions o!n to a set o+ si$-le o-erations that can #e -er+or$e
using a si$-le esign"
Increasing the -er+or$ance o+ a -rouct $ay involve re+ining the esign o+
e3isting co$-onents o+ a -rouct, rather than aing aitional -arts"
Si$-licity $ay #e a strength o+ a -hysical esign in $any circu$stances, an
a si$-le esign that has #een su#9ect to e3tensive re+ine$ent $ay result in a
$ore e++icient an relia#le -rouct that a esign that is #ase on a large
nu$#er o+ -arts"
Aing $ore -arts an co$-le3 o-erations $ay i$-rove -rouct
-er+or$ance in so$e cases, !ith a -ossi#le isavantage o+ higher costs an
less relia#le o-eration"
031
In other cases, aing -arts an co$-le3 o-erations $ay reuce the
-er+or$ance o+ a -rouct"
In so$e cases, the strength an &uality o+ a esign $ay #e eter$ine #y the
a$ount o+ esign e++ort that has #een s-ent in istilling a range o+ co$-le3
+unctions into a si$-le structure that is a#le to -er+or$ the +ull range o+
+unctions o+ the -rouct"
4.4.1.5. -anufaturing osts & (iffiult$
In esigning a -hysical -rouct esign, a nu$#er o+ issues $ay #e
consiere"
These $ay inclue the -er+or$ance o+ the -rouct, the -rouct si@e an
!eight, an the cost o+ the $aterials that $ay #e re&uire to -rouce the
-rouct"
=o!ever, the esign o+ a -rouct $ay also have a large i$-act on the costs
an i++iculty o+ $anu+acturing the -rouct"
In so$e cases, a $inor change to a -rouct esign $ay lea to the
$anu+acturing -rocess #eco$ing consiera#ly si$-ler"
In other cases, a $inor +eature or ele$ent o+ the -hysical structure $ay lea
to the $anu+acturing -rocess #eco$ing -articularly i++icult"
In these cases, the esign $ay i$-act on the e&ui-$ent that $ay #e re&uire
to -rouce the -rouct, the volu$e o+ -roucts that $ay #e -rouce !ithin
a -erio o+ ti$e, an the cost o+ the $anu+acturing -rocess itsel+"
In creating a -rouct esign, the cost an co$-le3ity o+ the $anu+acturing
-rocess $ay consiere as a signi+icant issue in selecting the +or$ an
structure o+ the esign"
4.4.1.!. Testing pro(ue performane
Testing the -er+or$ance o+ a -rouct $ay #e an essential ele$ent o+ an
e++ective esign -rocess"
036
In general, a esign $ay only #e i$-rove through testing the -er+or$ance
o+ the -rouct, an altering the esign o+ the -rouct to i$-rove the -rouct
-er+or$ance"
Dithout testing the results o+ a -rouct or o-eration, the -rocess or esign
itsel+ $ay not #e a#le to #e i$-rove"
This $ay involve engineering testing o+ -rototy-es, co$-uter si$ulations,
an +iel testing o+ -roucts uner conitions o+ actual usage"
In other situations, consiering co$$ents +ro$ custo$ers an custo$er
res-onse to various -roucts $ay ena#le the #usiness to evelo- $ore
e++ective -roucts an -rocesses"
4.4.2. 3ro(ut (evelopment pro%ets
A ne! -rouct $ay #e evelo-e over ti$e as -art o+ the ongoing #usiness
o-eration, or it $ay #e evelo-e as a s-eci+ic -ro9ect"
In the case o+ a -ro9ect evelo-$ent, this $ay involve the stanar -ro9ect
ste-s o+ evelo-ing the #asic -ro9ect goals an -lan, -er+or$ing a etaile
assess$ent, evelo-ing scheules an $anaging the -ro9ect through to
co$-letion"
In the case o+ a -rouct esign, tasks an ti$e+ra$es $ay relate to $a9or
ste-s rather than etaile iniviual tasks"
2or e3a$-le, the -ro9ect $ay inclue a -erio +or initial iscussions !ith
-otential clients, a -erio +or creating #asic esigns an -ossi#le a--roaches,
a revie! -erio an a test<$arketing stage, +ollo!e #y the etaile esign o+
the -rouct, an +inally arranging -rouction +acilities an contract
agree$ents"
5rouct esign $ay i++er +ro$ other -ro9ects such as construction, in there
$ay #e several -oints in the -rocess at !hich a ecision $ay #e $ae to
either continue to the ne3t stage, or to !ithra! +ro$ the -rouct esign ue
to the -rouct #eing i$-ractical or not $eeting a e$an !ithin a $arket"
4.4.3. 3ro(ut (esigns
000
4.4.3.1. -ar6et lea(ing (esigns
5roucts esigns $ay #e #ase on changing +ashions an e$an +or
-roucts !ithin the $arket +or the -roucts"
In other cases, ne! ieas +or -roucts $ay co$e +ro$ !ithin the #usiness"
In the case o+ $arket leaing esigns, ne! -roucts $ay #e $et !ith sur-rise
+ro$ the -otential custo$er #ase an +ro$ co$-etitors"
Market leaing esigns $ay -rovie a range o+ #ene+its to the #usiness
activity"
A strong -erio o+ sales $ay #e generate in the case o+ a success+ul -rouct"
Also, soli -rices an $argins $ay #e a#le to #e $aintaine +or a -erio o+
ti$e, until co$-etitors release -roucts that have si$ilar structures or
-er+or$ si$ilar +unctions to the ne! -rouct"
In the case o+ technology that can #e -atente, a ne! esign $ay ena#le the
#usiness to $aintain soli $argins over a $eiu$ ter$ ti$e +ra$e"
=o!ever, although -ro-rietary technology evelo-$ents $ay #e use+ul in
$aintaining long ter$ $argins, alternatives to the technology $ay #e
release over ti$e, an in the long ter$ the technology $ay #e su-ersee
#y i$-rove techni&ues or -rocesses"
4.4.3.2. -ar6et response (esigns
A $arket res-onse esign $ay involve -roucing a -rouct in res-onse to a
strong e$an +ro$ !ithin a $arket"
As !ith a $arket leaing esign, a $arket res-onse esign $ay also result in
a strong -erio o+ sales"
This a--roach $ay #e suita#le +or inustries !hich $ay #e highly +ashion<
conscious, !ith -articular ty-es o+ -rouct #eco$ing -o-ular or un-o-ular as
ti$e goes #y"
In aition to inustries such as +ashion an +il$, a nu$#er o+ inustries that
$ay #e traitionally consiere conservative or serious $ay also have an
ele$ent o+ +ashion involve in the e$an +or -articular ty-es o+ -rouct"
001
This a--roach $ay also #e suita#le in cases such as ne! inustries in !hich
ne! -roucts $ay #e neee, or in cases !here a -articular -rouct or
services $ay not #e availa#le !ithin a -articular area"
A $arket res-onse esign $ay have an avantage in that the re&uire esign
$ay #e eter$ine though investigating the custo$er interest in various
ty-es o+ -rouct"
In contrast, in the case o+ a $arket leaing esign, greater e3tre$es o+
outco$e $ay #e -ossi#le, !ith a ne! -rouct #eing either highly success+ul,
or a co$-lete +ailure"
4.4.3.3. +ustomise( pro(uts vs. stan(ar( sets
So$e #usiness o-erations $ay involve a stanar set o+ -rouct esigns,
!hich $ay #e -rouce in large volu$es"
5rouct esigns $ay #e u-ate on a regular #asis, an re-lace !ith
co$-letely ne! esigns over longer ti$e +ra$es"
In other cases, -roucts $ay #e evelo-e s-eci+ically to client orers"
This $ay inclue esigns that $ay #e -rovie #y clients, or it $ay involve a
custo$er selecting +ro$ a range o+ o-tions that $ay #e availa#le +or a
-rouct"
In so$e cases, a $anu+acturer $ay -rouce a set o+ stanar -roucts, an
$ay also -rouce li$ite esigns, -roucts #ase on custo$er selections,
an -roucts #ase on custo$er esigns"
4.4.3.4. 3a6age( servies
5rouct esign an evelo-$ent $ay #e a signi+icant issue in $anu+acturing
an other -rouction activities"
=o!ever, this issue $ay also a--ly to so$e service o-erations"
2or e3a$-le, :-ackage services; $ay involve co$#ining several services
into a single -ackage, in return +or a single +ee"
This $ay -rovie convenience +or the custo$er"
002
Also, this a--roach $ay #e -articularly #ene+icial !hen the -ackaging
arrange$ent is use to create an aitional +acility, rather than si$-ly
#unling several -roucts together as a $arketing activity"
This $ay occur !hen the o-eration o+ the -ackage coul not #e u-licate #y
-urchasing the iniviual ite$s se-arately"
2or e3a$-le, in the case o+ a structure +inancial transaction, a e#t +acility
an an asset $ay #e co$#ine into a single -rouct"
In this !ay, the cash +lo! +ro$ the asset $ay #e auto$atically re<irecte to
the e#t, !hich $ay reuce the risk o+ the e#t +acility an allo! lo!er
interest rates to #e charge"
This arrange$ent $ay not #e -ossi#le i+ each co$-onent o+ the -ackage !as
-urchase se-arately"
5ackage services $ay inclue -roucts or services that are -rovie #y
other #usinesses, as !ell as the #usiness itsel+"
Hsing this a--roach, a #usiness $ay #e a#le to create a -rouct that $ay
have consiera#le a--eal +or a custo$er, using services o+ the #usiness itsel+,
an co$-onents source +ro$ other #usinesses"
4.4.3.5. Ort.ogonal options
:Arthogonal; -rouct o-tions or -rouct +unctions $ay involve situations in
!hich several o-tions or +unctions $ay #e selecte ine-enently"
2or e3a$-le, a $achine $ay have settings +or three i++erent o-erating
-ara$eters"
These $ay #e escri#e in the +ollo!ing list"
5ara$eter A o-tion A, B or /
5ara$eter B o-tion A, B
5ara$eter / o-tion A, B or /
The +unctions o+ this $achine $ay #e selecte in various !ays"
003
A list selection $ay involve the +ollo!ing -ossi#le o-erating $oes"
5ara$eter A 5ara$eter B 5ara$eter /
Moe 1 / B A
Moe 2 A A B
Moe 3 B B /
In the list arrange$ent, the -ossi#le selections $ay #e chosen +ro$ a list o+
co$#inations"
In this e3a$-le, three o-erating $oes are availa#le, involving various
settings o+ the three $achine -ara$eters"
In an orthogonal selection arrange$ent, each -ara$eter $ay #e selecte
iniviually, rather than a +i3e list o+ o-tions #eing -rovie"
2or e3a$-le, in this case the +ollo!ing -ossi#le co$#inations o+ the
-ara$eter settings $ay #e selecte"
000
5ara$eter A 5ara$eter B 5ara$eter /
A A A
A A B
A A /
A B A
A B B
A B /
B A A
B A B
B A /
B B A
B B B
B B /
/ A A
/ A B
/ A /
/ B A
/ B B
/ B /
In the case o+ the orthogonal selection, the $achine $ay kno! #e use in 11
i++erent !ays, rather than the three i++erent !ays +ro$ the case in !hich the
o-erating $oes !ere selecte +ro$ a -ree+ine list"
By using iniviual selection o+ each +unction, the nu$#er o+ !ays in !hich
the $achine $ay #e use $ay #e increase in this e3a$-le +ro$ three to 11,
!ithout altering the esign o+ the $achine"
In the case o+ orthogonal selection, the nu$#er o+ -ossi#le co$#inations o+
o-tions $ay #e calculate using the +ollo!ing a--roach"
co$#inations P the nu$#er o+ o-tions +or each -ara$eter,
$ulti-lie together
In the -revious e3a$-le, there !ere three alternatives +or the +irst o-tion, t!o
alternatives +or the secon o-tion, an three alternatives +or the thir o-tion"
The nu$#er o+ co$#inations $ay then #e calculate using the +ollo!ing
e3a$-le"
00*
3 2 3 ns combinatio
11
This conce-t $ay a--ly to a range o+ #usiness situations"
In the case o+ -hysical -rouct esigns, creating -roucts in !hich each
+unction is selecte se-arately $ay result in the evelo-$ent o+ -roucts that
are +le3i#le an -er+or$ a !ier range o+ +unctions"
In contrast, o-erating e&ui-$ent through selecting -re<e+ine co$#inations
$ay result in +e!er +acilities #eing availa#le than i+ each -ara$eter !as
selecte iniviually"
In the case o+ o-tions that $ay #e selecte #y a custo$er +or a service or a
-hysical -rouct, a si$ilar situation $ay a--ly"
In this case, allo!ing the custo$er to $ake a selection +or each co$-onent o+
the -ackage se-arately, rather than selecting +ro$ several -re<e+ine
co$#inations, $ay allo! a larger nu$#er o+ -rouct co$#inations to #e
o++ere, an $ay result in increase sales"
4.4.4. Business issues
In aition to -hysical esign or creating a service esign, various #usiness
issues $ay also #e involve as -art o+ the overall esign o+ a -rouct"
4.4.4.1. :olumes? margins & priing
4.4.4.1.1. :olumes
Target volu$es o+ -rouction $ay #e consiere in esigning a -rouct, an
in selecting -ricing levels, -rouction +acilities an so on"
In the case o+ co$$oity -roucers, +or e3a$-le, very large volu$es $ay #e
necessary in orer to o-erate a sustaina#le #usinesses o-eration"
00)
At the other e3tre$e, s-ecialty, custo$ise an han<$ae ite$s $ay
involve lo! volu$es, !ith $argins -ossi#ly #eing higher than in the case o+
high<volu$e -rouction"
4.4.4.1.2. +ost strutures & priing
The costs o+ various stages o+ the -rouct creation an istri#ution $ay also
#e consiere !hen esigning a -rouct"
This $ay involve costs such as $aterials, -rouction +acilities, sta++ costs,
#usiness -re$ises, an istri#ution arrange$ents"
4.4.4.1.3. -argins
In general there $ay #e a trae<o++ #et!een volu$es an $argins"
=igh volu$e ite$s $ay #e o++ere at lo! -rices an !ith lo! $argins, !hile
lo! volu$e -rouction $ay nee to #e o++ere +or sale at higher -rices an
$argins, in orer to cover +i3e costs an $aintain -ro+ita#ility"
The choice o+ target $argins an sales volu$es $ay #e a $a9or issue in the
esign o+ a -rouct"
The ecision to -urchase a -rouct is $ae #y the custo$er, not the #usiness"
7e$an +or the -rouct $ay vary +ro$ one custo$er to another"
The #usiness $ay chose the selling -rice an $argin, an the $arket $ay
res-on #y elivering a certain volu$e o+ sales"
I+ the #usiness selects a high $argin, a lo! volu$e o+ sales $ay result, as
only a s$all nu$#er o+ custo$ers !ith a strong interest in the -rouct $ay
chose to -urchase the ite$"
/onversely, i+ the #usiness selects a lo! $argin, strong sales $ay result, ue
to the lo! -rice o+ the -rouct"
The #alance o+ $argins an volu$es $ay #e eter$ine #y the -rice levels
o+ si$ilar -roucts"
008
In so$e cases, high<$argin s-ecialty ite$s an lo!<$argin #asic ite$s $ay
#e -rouce an $arkete as se-arate -rouct lines, !ith se-arate $arkets
e3isting +or each ty-e o+ -rouct"
4.4.4.2. /ee strutures
2ees $ay #e charge +or -roucts an services in a variety o+ !ays"
The +ee structure o+ a -rouct $ay #e a $a9or co$-onent o+ the -rouct
esign"
In the case o+ a $anu+acture ite$, this $ay involve si$-ly setting the
!holesale sale -rice"
=o!ever, changing this value $ay co$-letely alter the esign o+ the -rouct,
+ro$ the si@e an +eatures o+ the -rouct, to its construction $etho, choice
o+ -rouction +acilities, an -lanne volu$es o+ -rouction"
In the case o+ services, +ees $ay #e charge in a !ie variety o+ !ays"
This $ay inclue so$e o+ the +ollo!ing alternatives"
A +i3e +ee +or a s-eci+ic service"
An on<going regular +ee"
A regular usage +ee #ase on the a$ount o+ usage o+ a service, or
the volu$e o+ a -rouct elivere or use"
A -ercentage +ee #ase on the si@e o+ a transaction"
An hourly rate or other ti$e<#ase +ee"
A -ro-ortion o+ the service outco$e, such as a -ercentage o+ a
success+ul court action, or a -ercentage o+ the custo$erCs sales, in
cases such as su#<lease retail s-ace"
In the case o+ istri#ution arrange$ents, +ee structures $ay inclue so$e o+
the +ollo!ing -ossi#le alternatives"
001
A -ercentage co$$ission #ase on the value o+ the transaction"
A +i3e ollar co$$ission +or each transaction"
An<going regular co$$issions, such as a $onthly +ee or a
-ercentage +ee, in return +or arranging an on<going service
agree$ent such as a -ro-erty $anage$ent service or invest$ent
$anage$ent service"
4.4.4.3. Distribution
A istri#ution arrange$ent $ay nee to #e consiere as -art o+ a -rouct
esign"
This $ay involve sales to !holesalers, retailers, the irect -u#lic, istri#ution
through thir<-arty arrange$ents !ith other #usinesses, or other
arrange$ents"
4.4.4.4. Bun(le( & 7nbun(le( pro(uts
Bundled and multi-function products
Bunle -roucts $ay involve a nu$#er o+ i++erent +eatures !ithin a single
-rouct"
This arrange$ent $ay #e use in service #usinesses, !here a single +ee $ay
cover an agree$ent that $ay inclue a range o+ i++erent services"
A si$ilar conce-t $ay a--ly in the case o+ certain ite$s o+ e&ui-$ent, !hich
$ay -er+or$ several i++erent +unctions !ithin a single $achine"
Bunle -roucts $ay increase the sales volu$e o+ certain ite$s, such as
incluing ite$s !ith a -rouct that $ay involve a #ene+it, #ut !hich $ay not
nor$ally #e -urchase as a co$-letely se-arate -rouct"
In so$e cases this arrange$ent $ay reuce so$e a$inistration costs #y
co$#ining several o-erations into a single transaction"
006
By increasing volu$es, a lo! -rice $ay #e o++ere +or the co$#ine
-ackage, !hich $ay also attract increase sales"
Bunle -roucts $ay also inclue -roucts or services that $ay #e su--lie
#y other #usinesses"
This $ay attract sales !here the -rouct $ay $eet a e$an in the $arket,
-articularly !here there $ay #e an essential -art o+ the -rouct that the
#usiness $ay not -rouce irectly"
The #usiness $ay -ay a +ee to the other #usiness +or the right to inclue an
e3ternal -rouct or service !ithin the -ackage, they $ay receive a +ee as a
istri#utor, or the arrange$ent $ay #e on a no<+ee #asis, on the #asis that the
-ackage $ay increase the sales o+ #oth iniviual ite$s"
=o!ever, there are $ay #e several isavantages !ith a #unle -rouct"
A custo$er in this case $ust -ay to -urchase all o+ the ite$s !ithin the
-rouct"
I+ there !ere several ite$s that the custo$er i not !ant, then this $ay
reuce sales as the custo$er $ay select alternative -roucts +or the
co$-onents that they !ishe to -urchase"
Also, #unle -roucts $ay #e co$-le3 in structure"
This $ay result in $ore co$-le3 $anu+acturing -rocesses +or $ulti-le
+unction e&ui-$ent than +or single<+unction -roucts, !hich $ay increase
costs an reuce volu$e ca-acity"
This $ay also #e a isincentive to custo$ers !ho $ay -re+er -roucts !hich
-er+or$ a single +unction or o-eration"
Bunle service -roucts $ay #e $ore co$-le3 to a$inister than single
-ur-ose -roucts, an this $ay lea to higher a$inistration an co$-uter
so+t!are costs, an $ore co$-le3 internal re-orting an -ro+ita#ility
analysis"
Bunle -roucts !ere !iely use in the earlier ays o+ insurance, !here a
single -rouct $ay inclue li+e insurance, invest$ent, a savings -lan, an a
loan arrange$ent +or te$-orary !ithra!als"
0*0
0n"undled and single-function products
Hn#unle -roucts are -roucts in !hich each -rouct -rovies a single
+eature or o-eration"
This $ay allo! the custo$er to select !hich -roucts they !ish to -urchase,
an in !hich co$#inations"
Hn#unle -roucts $ay #e si$-ler than #unle -roucts, !hich $ay lea
to lo!er costs o+ a$inistration an syste$s re&uire$ents, si$-ler analysis
an re-orting, an higher volu$es"
A -rouct line that inclue several high<volu$e un#unle -roucts that
coul #e co$#ine in various !ays $ay involve !ith lo!er costs an a
higher volu$e ca-acity that the a syste$ that involve $ore co$-le3
-roucts"
=o!ever, the choice o+ -rouct esign $ay #e eter$ine #y the $arket
e$an +or i++erent ty-es o+ -rouct, an the -roucts o++ere #y
co$-etitors"
4.4.5. Test mar6eting
Test $arketing $ay involve -roucing sa$-les, esigns an service
escri-tions, an a--roaching -otential custo$ers to gauge the level o+
interest in the -rouct"
In the case o+ a long an e3-ensive esign -rocess, this -rocess $ay #e one
at several -oints through the -ro9ect, to ensure that the conce-t an esign
that !as #eing evelo-e $ay lea to a success+ul -rouct #eing create"
4.4.!. 3ro(ution
5rouction o+ a co$-lete -rouct $ay #e hanle in a nu$#er o+ !ays"
%3isting -rouction +acilities an o-erations coul #e use, or ne! +acilities
coul #e create"
The esign itsel+ coul #e license to e3ternal $anu+actures"
0*1
Alternatively, the #usiness $ay arrange +or thir -arties to -er+or$ the
-rouction on a contract #asis"
5rouction $ay #e $anage #y the #usiness itsel+, #y a s-ecialist -rouction
$anage$ent #usiness, or -rouce #y an e3ternal $anu+acturer uner a
contract arrange$ent"
".#. Business infrastructure
Business in+rastructure involves the internal +acilities an resources that the
#usiness o-eration is #uilt on"
This $ay inclue co$-uter syste$s, esign centres, a$inistration,
$anu+acturing o-erations, an so on"
Business in+rastructure -rovies the +acilities that are necessary to evelo-
ne! -roucts an $arkets, an to su--ort the on<going o-erations o+ the
#usiness
Although #usiness in+rastructure coul #e consiere to #e a #usiness $oel
in so$e res-ects, the issue o+ in+rastructure a--lies to all #usiness o-erations"
This inclues s$all enter-rises as !ell as large #usiness organisations"
In the case o+ s$all enter-rises or sole traers, a single iniviual $ay
-er+or$ several roles"
Also, i++erent activities $ay occur at i++erent ti$es, an so$e ele$ents o+
the in+rastructure $ay not o-erate on a continual #asis"
2or e3a$-le, the resources o+ the enter-rise $ay #e +ocuse on -rouct
evelo-$ent +or a -erios o+ ti$e, an then on $anu+acturing, rather than
#oth o-erations occurring in -arallel"
=o!ever, regarless o+ the situation, #uiling an o-erating the in+rastructure
o+ the #usiness re$ains a se-arate task +ro$ -er+or$ing the #usiness
o-erations the$selves"
4.5.1.1. 4nfrastruture vs. operation
The #usiness activity can #e #roken into t!o sections"
0*2
This involves the in+rastructure o+ the #usiness, an the actual o-eration o+
the #usiness"
The in+rastructure -rovies the +acilities that are neee to conuct a #usiness
o-eration"
The o-eration itsel+ then uses these +acilities to conuct the #usiness activity,
such as su--lying -roucts to custo$ers"
4.5.1.2. +osts of infrastruture
In+rastructure activities $ay re&uire consiera#le +uning, #oth on a ca-ital
e3-ense #asis, an on an on<going cash +lo! #asis"
2or e3a$-le, a -rouct esign centre or a so+t!are evelo-$ent centre $ay
involve a signi+icant on<going e3-ense"
=o!ever, #usiness in+rastructure also -rovies the necessary +acilities to
e3-an the #usiness into ne! $arkets, su--ort e++icient an high volu$e
-rocessing o-erations, an evelo- the +uture o+ the #usiness"
4.5.1.3. +ontinuous & pro%et*base( ativities
In+rastructure sections -er+or$ either -ro9ect<#ase o-erations, or continuos
o-erations"
Manu+acturing o-erations, a$inistration services an co$-uter syste$s
su--ort are all continuous o-erations that $ay #e -er+or$e as -art o+ the
#usiness in+rastructure"
5ro9ect<#ase o-erations $ay inclue -rouct esign an evelo-$ent,
co$-uter so+t!are evelo-$ent, an evelo-ing a ne! $arket +or a -rouct"
4.5.1.4. /un(ing
In+rastructure can #e +une on a cash +lo! #asis, or on a ca-ital allocation
#asis"
0*3
/a-ital is use +or large -ro9ects"
This $ay involve allocating a su$ o+ ca-ital to +un a -ro9ect, !ith the
returns +ro$ the -ro9ect +lo!ing +ro$ +uture inco$e"
In the case o+ continuous services, a sta#le level o+ cash +lo! $ay #e
involve"
So$e -ro9ect<#ase areas $ay #e +une on a cash +lo! #asis"
This $ay involve -roucing s$all -ro9ects on a continual #asis, or
evelo-ing large -ro9ects at the rate that is su--orte #y the cash +lo!"
4.5.1.5. 4nternal & e)ternal servies
%ither internal or e3ternal services can #e use +or in+rastructure services"
%3ternal services $ay have the #ene+it o+ econo$ies o+ scale an s-ecialise
kno!lege, !hich $ay ena#le the service #usiness to -er+or$ the services
$ore e++ectively than an in<house area"
A $a9or #ene+it !ith e3ternal services is the a#ility to increase or ecrease
the volu$e o+ -rocessing as #usiness conitions change"
This cannot #e one easily !ith an in<house area, !hich has a largely +i3e
cost an ca-acity"
The ca-acity an cost $ay #e too high uring ti$es o+ slo! sales, an there
$ay #e insu++icient ca-acity uring ti$es o+ high sales e$an"
Hse o+ services such as these also increases the +le3i#ility o+ the #usiness to
aa-t to change circu$stances, such as iscontinuing -roucts or
co$$encing o-erations in ne! $arkets"
%3ternal services $ay also #e use in the case o+ large -ro9ects !ere the
#usiness i not have the +acilities to co$-lete the -ro9ect irectly"

The use o+ internal services is relevant in cases !here a etaile kno!lege
o+ the #usiness itsel+ is necessary, such as in the -re-aration o+ accounts an
+inancial state$ents"
Internal services are use in cases !here an e++ective e3ternal service is not
availa#le"
0*0
Also, $aintaining internal services allo!s the #usiness to e3ercise control
over the &uality stanars o+ an o-eration"
%3ternal service -roviers vary !iely in the level o+ service an the
stanar o+ results that are o++ere"

4.5.1.!. 4nternal .arging
In so$e #usiness structures, internal service areas charge each other +or
services"
This is usually #ase on accounting entries !ithin the accounts o+ the
#usiness, rather than actual trans+ers o+ cash #et!een #ank accounts"
2or e3a$-le, a -rouct esign centre $ay source ca-ital to evelo- a ne!
-rouct, an then charge licence +ees to the $anu+acturing o-eration in return
+or the use o+ the esign"
The internal charging a--roach $ay have a nu$#er o+ -otential #ene+its"
%ach area coul #e consiere a se-arate #usiness, an $anage accoring to
the +inancial structure an resources o+ the area"
This $etho $ay allo! -ro#le$s !ithin iniviual areas to #e highlighte,
ranging +ro$ insu++icient ca-ital to an overca-acity in co$-arison to the rest
o+ the #usiness"
Also, each area coul then irectly co$-are the service -rovie an the +ees
charge #y other areas !ith e3ternal service -roviers"
Although the internal charging a--roach $ay have consiera#le #ene+its in
conce-t, in -ractice $any atte$-ts to i$-le$ent this a--roach have not #een
-articularly success+ul"
This $ay occur ue to the +act that a #usiness area is o+ten not given the
-ractical alternative o+ changing service -roviers to another service"
Dhen isagree$ents an is-utes arise, this $ay si$-ly result in #oth -arties
retreating to their e3isting o-erations, !ith no changes #eing $ae, an !ith
the original -ro#le$s continuing as #e+ore"
0**
This -ro#le$ $ay #e less severe !ith e3ternal service -roviers, as an
alternative service can #e selecte !hen the service -rovie oes not $atch
the agree level"
4.5.1.7. 7sing infrastruture
Ance the in+rastructure is in -lace an o-erational, the in+rastructure +acilities
can #e use to o-erate the #usiness"
This $ay involve the -rouct esign centre creating -roucts, the
$anu+acturing o-eration -roucing ite$s +or sale, an the a$inistration
centre -rocessing accounts"
The #usiness o-eration itsel+ involves using the in+rastructure +acilities to
eliver -roucts to custo$ers an evelo- ne! $arkets"
4.5.1.8. 4nfrastruture vs. operation
I+ a large -ro-ortion o+ the #usinessCs resources are evote to in+rastructure,
then the #usiness $ay have e++icient high<ca-acity resources, !ith high +i3e
costs, that are not +ully utilise ue to the lack o+ resources evote to
o-erating the #usiness an evelo-ing $arkets"
At the other e3tre$e, a lack o+ invest$ent in in+rastructure issues $ay lea to
a #usiness !ith large volu$es o+ $anual -rocessing, li$ite -rouct esigns,
a high cost<-er<unit an sli$ $argins"
An a--ro-riate -ro-ortion o+ the #usinessCs resources shoul generally #e
evote to in+rastructure, co$-are to general #usiness o-erations, in orer
to ensure that the #usiness o-erates e++ectively"
4.5.1.9. 3roblems 5it. infrastruture
4.5.1.9.1. 'tivities t.at never omplete
In so$e cases, a -ro9ect or research area can egenerate into an on<going
evelo-$ent that never co$-letes"
0*)
Dhen these situations arise, this can #eco$e a -er$anent an signi+icant
rain on cash +lo!"
The risk o+ this situation arising $ay #e reuce #y taking so$e o+ the
+ollo!ing ste-sE
Arganising several s$all -ro9ects rather than one very large -ro9ect"
%nsuring that clear goals an ti$e +ra$es are evelo-e +or each
-ro9ect"
%nsuring that general research areas -rouces regular results that
have an e&uivalent #ene+it to the #usiness co$-are !ith the costs
involve"
Revie!ing all e3-ense areas regularly to ensure that they are
-er+or$ing a +unction that is necessary +or the #usiness o-eration, or
that there is a clear en to the negative cash +lo! in sight, !ith a
clear result e3-ecte !hen the -ro9ect is co$-lete"
This -ro#le$ can occur -articularly !ith so+t!are evelo-$ent -ro9ects,
!hen in so$e cases an overly<a$#itious -ro9ect enters a state o+ continuous
evelo-$ent, !hen it is likely that a co$-lete an !orking syste$ !ill
never actually #e create"
This -ro#le$ also occurs in research areas, !hich research $ay graually
change irection into areas that o not -rouce an o-erational result that
coul #e i$-le$ente #y the #usiness !ithin a -ractical -erio o+ ti$e"
4.5.1.9.2. 7nsustainable operations
In so$e cases, the cash rain +ro$ a large evelo-$ent -ro9ect or a large
research area $ay lea to negative cash +lo! +or the #usiness overall"
This is an unsustaina#le situation, !ith the net assets o+ the #usiness +alling
to @ero as the ca-ital is consu$e #y the cash out+lo!"
In the case o+ large -ro9ects, ste-s shoul generally #e taken to ensure that a
-ro9ect is co$-lete an that the e3-enses en !ithin a -ractical -erio o+
ti$e"
0*8
I+ a clear en to the -ro9ect !ithin reasona#le ti$e -erio cannot #e
eter$ine, then the -ro9ect $ay #e iscontinue to restore cash +lo! to a
-ositive value"
In the case o+ -er$anent evelo-$ent areas, such as research an
evelo-$ent o-erations, the area coul #e reuce in si@e to reuce the
e3-ense level"
4.5.1.9.3. Overapait$
Averca-acity occurs !hen an in+rastructure area is create that is too large to
#e su--orte #y the ongoing o-erations o+ the #usiness, or is not in
-ro-ortion to the ca-acity o+ the other in+rastructure areas !ithin the
#usiness"
In orer to o-erate e++ectively, the ca-acity o+ each ele$ent o+ the
in+rastructure $ust #e in -ro-ortion to the other ele$ents"
Also, the total ca-acity o+ the in+rastructure syste$ shoul not #e too large or
too s$all to su--ort the #usiness o-erations, an the ca-acity shoul not
e3cee the unerlying e$an !ithin the $arket +or the #usinessCs -roucts"
4.5.1.1".T$pes of infrastruture
4.5.1.1".1. Operations & servie entres
4.5.1.1".1.1. -anufaturing operations
Manu+acturing o-erations -rouce -hysical ite$s +ro$ the ra! $aterials"
Manu+acturing $ay involve -rouction +acilities an e&ui-$ent, inventory
an -rouction $anage$ent, an so on"
Manu+acturing o-erations $ay also -er+or$ contract $anu+acturing +or
e3ternal #usinesses, as !ell as $anu+acturing +or internal o-erations"
Hner an internal charging syste$, a $anu+acturing o-eration $ay -ay
licence +ees to a esign centre +or the use o+ -rouct esigns"
0*1
This is the sa$e -rocess than !oul #e +ollo!e i+ the $anu+acturing
o-eration license esigns +ro$ e3ternal #usinesses"
4.5.1.1".1.2. +omputer soft5are (evelopment
/o$-uter syste$s are a $a9or co$-onent o+ #usiness in+rastructure"
Although the cost o+ co$-uter har!are an su--ort $ay #e signi+icant, the
$a9or cost +or $any #usinesses involves the cost o+ -urchasing or evelo-ing
so+t!are"
So+t!are syste$s $ay su--ort o-erational -rocess in large volu$es !ith
e++icient -rocessing, -rovie #usiness in+or$ation that can #e use in
$anaging the #usiness an evelo-ing ne! $arkets, an #e use in -rouct
esign an evelo-$ent"
Many $eiu$ si@e an large #usinesses $aintain internal so+t!are
evelo-$ent areas"
Although general so+t!are such as accounting an -ersonal co$-uter
so+t!are can #e -urchase co$$ercially, so+t!are than eals !ith the
#usinessCs -roucts an -rocesses $ust generally #e !ritten s-eci+ically +or
the #usiness"
Iniviual -ro9ects $ay involve internal -er$anent sta++, iniviual contract
evelo-ers, or an e3ternal #usiness !hich $ay -rouce the syste$ on a
contract #asis"
So+t!are -urchase an evelo-$ent is a $a9or e3-ense +or $any #usinesses"
Although this is o+ten vie!e as a cash +lo! e3-ense, iniviual -ro9ects are
e++ectively a ca-ital e3-ense"
A $ore accurate +inancial analysis o+ so+t!are $ay involve recoring
evelo-e syste$s as assets, an e-recating the asset over the e3-ecte li+e
o+ the syste$"
As !ith -hysical e&ui-$ent, co$-uter syste$s are o+ten -atche together +or
long a+ter their use+ul !orking li+e has ene"
In these situations, the -ro#le$s that $ay arise !ith so+t!are syste$s are
si$ilar to the -ro#le$s that $ay occur !ith e&ui-$ent"

0*6
5rocessing $ay #e slo!, error rates $ay #e high, a large a$ount o+ $anual
in-ut an a9ust$ent $ay #e neee, an so on"
In these cases, a so+t!are syste$ shoul generally #e e-reciate over its
use+ul li+e, an then scra--e an re<!ritten, or an u-ate so+t!are -ackage
coul #e -urchase"
4.5.1.1".1.3. 3ro(ut (esign
A -rouct esign centre $ay esign an evelo- ne! -roucts"
This $ay inclue so$e o+ the +ollo!ing areasE
The -hysical esign, incluing engineering evelo-$ent, testing
-rototy-es, co$-uter si$ulation an so on"
7esigning -acke services -roucts"
7evelo-ing the cost structures an -lanne volu$es +or ne!
-roucts"
7esigning the $anu+acturing -rocesses necessary to -rouce the
-rouct"
Researching $arket interest in the -rouct, an aa-ting the esign
to $ee $arket interest"
A -rouct esign centre coul also esign -roucts that are not use #y the
#usiness, an licence these -roucts to e3ternal #usinesses"
,icence +ees coul #e charge to other areas, to allo! the esign centre to
o-erate on an ine-enent co$$ercial #asis"
4.5.1.1".1.4. '(ministration
A$inistration involves -rocessing recei-ts, $aking -ay$ents, $aintaining
recors, an istri#uting in+or$ation, such as state$ents, to custo$ers"
0)0
A$inistration $akes heavy use o+ co$-uter -rocessing, an in general an
a$inistration so+t!are syste$ $ust #e !ritten #e+ore a ne! -rouct can #e
e++ectively a$inistere"
=igh volu$e a$inistration involves the use o+ high<s-ee -rinters, $ail
sorting $achines, ata entry o-erators, an ra-i co$-uter -rocessing to
-rocess large volu$es o+ transactions is short -erios o+ ti$e, at a lo! cost<
-er<unit"
This ty-e o+ +acility can #e use in contract service -roviers that o-erate
+acilities +or $any clients, an in cases !here the #usiness eals !ith a large
nu$#er o+ custo$ers, such as large retail #anking o-erations"
Hsing an internal charging syste$ that involves -ay$ents such as +ees +or
a$inistration transactions $ay #e use+ul in eter$ining the -ro+ita#ility o+
iniviual -roucts"
4.5.1.1".1.5. -ar6et (evelopment
A $arket evelo-$ent in+rastructure area $ay involve evelo-ing ne!
$arkets +or the #usinessCs -roucts"
This !oul i++er +ro$ the o-erational sales an $arketing area, !hich
!oul $arket the e3isting -roucts to custo$ers, conuct -resentations, an
evelo- conce-ts +or ne! -roucts"
A $arket evelo-$ent area coul evelo- $arkets !ithin ne! regions,
investigate ne! grou-s o+ -roucts, arrange ne! istri#ution channels +or the
#usinessCs -roucts an so on"
4.5.1.1".1.!. Treasur$
A treasury o-eration $ay organise the ca-ital raisings o+ the #usiness, such
as the issue o+ #ons to investors, an $anage the structure o+ the #usinessCs
e#t"
Treasuries also $anage cash +lo!, an $ay hol -ort+olios o+ heging
instru$ents to $anage the #usinessCs risk e3-osure to co$$oity -rices,
interest rates, an +oreign e3change rates"
0)1
So$e treasury or traing areas also o-erate s-eculative activities as a -ro+it<
$aking activity"
=o!ever, traing o-erations !ithin general #usiness activities are o+ten not
-ro+ita#le in the long ter$"
This $ay occur +or several reasons"
In the case o+ assets such as shares, -ro-erty an #ons, inco$e $ay #e
receive +ro$ the asset" In the case o+ shares an -ro-erty the asset $ay also
increase in value over ti$e"
=o!ever, in the case o+ t!o<sie instru$ents such as +utures an o-tions,
the trans+er is a @ero<su$ event"
At the e3-iry o+ the contract, a trans+er occurs in one irection or the other,
e-ening on the -rice $ove$ents uring the -erio, !ith the -ro+it an loss
o+ the t!o -arties cancelling to @ero"
In a case o+ s-eculation involving t!o<sie instru$ents, so$e traes $ay
generate a -ro+it !hile others generate a loss, an evelo-ing an o-eration
that is -ro+ita#le over the long ter$ $ay #e i++icult on this #asis"
Also, an e++ect kno!n as the :e++icient $arkets; e++ect $ay a++ect the returns
+ro$ traing activities, as o--ose to long ter$ invest$ent in assets"
The e++icient $arkets e++ect suggests that all current in+or$ation is alreay
inclue in setting current -rices"
In this situation, -urchasing an asset at any -oint in ti$e $ay only result in a
long ter$ return, !ith consistent short<ter$ returns #eing i++icult or
i$-ossi#le, as kno!n in+or$ation $ay alreay #e inclue in setting the
-rice, an une3-ecte events $ay #e either -ositive or negative +or the -rice
o+ the asset"
4.5.1.1".2. #tati infrastruture
In aition to the resource areas !ithin the #usiness, a nu$#er o+ static
in+rastructure co$-onents $ay also #e use"

This coul inclue so$e o+ the +ollo!ing ite$s"
0)2
4.5.1.1".2.1. +omputer failities
The co$-uter +acilities o+ the #usiness inclue the co$-uter har!are,
so+t!are, an su--ort services"
This allo!s a +ully o-erational in+or$ation technology syste$ to #e
$aintaine"
A range o+ i++erent alternatives are availa#le +or each -art o+ the structure,
incluing the har!are, so+t!are an su--ort"
%&ui-$ent can #e -urchase, lease, or -rovie #y an e3ternal #usiness
uner a contract arrange$ent"
In so$e cases a single e3ternal venor is use to su--ly har!are, so+t!are,
an on<going su--ort"
In other cases a co$#ination o+ internal resources an e3ternal sources are
use to evelo- an $aintain the in+or$ation technology in+rastructure"
So+t!are can #e -urchase, lease in so$e cases, evelo-e in<house, or
evelo-e e3ternally uner a so+t!are evelo-$ent contract"
Su--ort can #e -rovie #y an in<house area, or #y an e3ternal service
-rovier"
".&. ,(ministration
A$inistration involves $aking -ay$ents, -rocessing -ay$ents +ro$
custo$ers, an kee-ing recors o+ various kins"
Recors inclue etails o+ custo$ers an current agree$ents !ith custo$ers,
accounting in+or$ation, an other in+or$ation such as su--ly orers"
A$inistration is a la#our<intensive activity an $ay involve large volu$es
o+ ocu$ents +or invoices, state$ents, custo$er agree$ents an so on"
4.!.1. +omputer s$stems
/o$-uter -rocessing is heavily use in a$inistration"
0)3
An a$inistration syste$ ty-ically contains a large ata#ase recoring all
relevant in+or$ation, together !ith -rocessing +unctions +or -rinting
state$ents, generating transactions an so +orth"
Accounting recors are o+ten ke-t in a se-arate accounting syste$ +ro$ the
-rouct an custo$er etails, as a range o+ accounting syste$s are
co$$ercially availa#le"
A$inistration syste$s are ty-ically !ritten s-eci+ically +or the #usiness an
the -roucts that are a$inistere"
These syste$s an $ay #e evelo-e in<house, or e3ternally as a contract
evelo-$ent -ro9ect"
In so$e cases, co$$ercial so+t!are syste$s are availa#le +or s-eci+ic ty-es
o+ activity, such as a$inistering insurance -roucts or $anu+acturing
inventory $anage$ent"
A$inistration areas vary !iely in the level o+ $anual -a-er -rocessing that
is -er+or$e, co$-are to the use o+ co$-uterise -rocessing"
2or e3a$-le, s$all enter-rises an the a$inistration o+ ne! -roucts !ithin
larger #usinesses $ay involve a large a$ount o+ $anual -rocessing using
-a-er +iles, !ith #asic co$-uter entries +or ite$s such as recors o+ -ay$ents
receive"
Manual -rocessing $ay #e e3-ensive, an this a--roach also li$its the
volu$es that can #e -rocesse an the turn<aroun ti$es that can #e achieve
#y the o-eration"
A signi+icant ca-ital cost $ay #e involve in -urchasing or evelo-ing a
co$-uterise a$inistration syste$"
=o!ever, in general the total costs uner this a--roach are lo!er than using a
$anual a$inistration $etho"
This is a si$ilar situation to $anu+acturing, !here invest$ent in high
ca-acity, e++icient -rouction +acilities generally leas to increase ca-acity,
reuce error rates an a lo!er cost<-er<unit"
4.!.2. Development of a(ministration s$stems
0)0
There are t!o -otential -ro#le$s !ith the use o+ co$-uterise -rocessing"
This involves the cost o+ the syste$, an the ti$e elay involve in the
evelo-$ent"
,arge a$inistration syste$s, as use in #anking, insurance, $anu+acturing
an so on, can cost $any $illions o+ ollars to evelo-"
=o!ever, this cost is generally less than the alternative o+ -er+or$ing all
a$inistration $anually"
A secon -otential -ro#le$ relates to ti$e elays"
The evelo-$ent o+ a$inistration syste$s generally re&uires a $ini$u$ o+
several $onths, an in the case o+ large syste$s, several years $ay -ass
#e+ore the syste$ is +ully o-erational"
This $ay -resent a -ro#le$ +or the launch o+ ne! -roucts, !hich cannot #e
e++ectively a$inistere until a so+t!are syste$ is availa#le"
In -ractice, this generally leas to a -erio o+ ti$e !here a$inistration is
-er+or$e using a co$#ination o+ $anual -rocesses, alterations to e3isting
syste$s, an #asic te$-orary syste$s"
This -rocess can lea to large costs, high error rates, an slo! -rocessing
ti$es"
This -ro#le$ $ay #e -articularly signi+icant !hen this situation #eco$es a
-er$anent conition o+ the o-eration"
The risk o+ these -ro#le$s arising $ay #e reuce #y using several s$all
syste$s rather than one large syste$, an #y ensuring that syste$s are
esigne +or +le3i#le o-erations"
The use o+ e3ternal contract evelo-$ent $ay also reuce so$e -ro#le$s
!ith ti$e elays"
The resources o+ an internal evelo-$ent area are generally set at the level
re&uire to su--ort the on<going o-erations o+ the #usiness"
=o!ever, !hen a large -ro9ect is re&uire, this $ay result in a long -erio o+
ti$e #eing re&uire to co$-lete the evelo-$ent"
0)*
In these cases, a solution #ase on a large nu$#er o+ resources, +or a short
-erio o+ ti$e, !oul #e -re+era#le to a solution involving a s$all nu$#er o+
resources +or a long -erio o+ ti$e"
The total cost in each case $ay #e si$ilar, as the sa$e volu$e o+ !ork is
-er+or$e in either case, ho!ever the ti$e elays involve in the secon
a--roach coul have a signi+icant i$-act on the #usiness o-erations"
4.!.3. 2ig. volume a(ministration
=igh volu$e a$inistration occurs in situations !here the #usiness involves
a large nu$#er o+ transactions"
Htility #usinesses that su--ly gas an electricity to the general -u#lic are
e3a$-les o+ this"
These #usinesses receive a large volu$e o+ iniviual -ay$ents an issue a
large volu$e o+ state$ents an invoices"
=igh volu$es can #e -rocesse #y ensuring that co$-uter syste$s are
availa#le that can -er+or$ the +ull range o+ transactions that are re&uire"
7ata entry can #e -er+or$e #y ata entry o-erators, !hile so$e o-erations
also inclue auto$ate scanning that can in-ut so$e ty-es o+ in+or$ation #y
scanning -a-er +or$s irectly"
Businesses that -er+or$ high volu$e a$inistration can su--ort lo! costs
-er transaction #y s-reaing the +i3e costs, such as the evelo-$ent o+
co$-uter syste$s, across a large nu$#er o+ transactions"
These o-erations $ay inclue +acilities such as high s-ee -rinters an $ail<
sorting $achines, that $ay increase the s-ee o+ -rocessing, increase the
volu$e o+ -rocessing that can #e -er+or$e, an reuce the cost -er
transaction"
4.!.4. Eletroni lin6s
%lectronic trans+ers o+ -ay$ents an u-ating o+ in+or$ation $ay reuce
a$inistration costs"
0))
In the case o+ retail custo$ers, the -ay$ent $etho is generally chosen #y
the custo$er, not the #usiness"
=o!ever, an increasing -ro-ortion o+ -ay$ents are #eing $ae
electronically"
This a--roach $ay also reuce ti$e elays an reuce error rates"
%lectronic links are o+ten use to trans+er large volu$es o+ ata #et!een
#usinesses"
This can occur through a live connection, or through a #ulk trans+er, using
ata +iles store on $eia such as a ata ta-e, or trans+erre through an on<
line connection"
2or e3a$-le, a #usiness -rocessing irect e#its +ro$ custo$er #ank
accounts !oul su#$it a ata ta-e to the #ank !hen transactions !ere ue,
!ith the transactions #eing irectly -rocesse #y the #anking syste$"
4.!.5. +ontrat a(ministration
/ontract a$inistration involves using an e3ternal a$inistration service to
-er+or$ a$inistration"
This $ay result in cost savings ue to the econo$ies o+ scale that are
-ossi#le !ith larger volu$es"
2ees $ay #e #ase on +i3e $onthly +ees, a +ee -er transaction, or so$e other
$etho"

A contract a$inistration service is generally governe #y a Service ,evel
Agree$ent"
This s-eci+ies the ty-es o+ transactions that !ill #e -rocesse, the +ee
arrange$ents, an the turn<aroun ti$es +or each ty-e o+ transaction"
In the case o+ e3ternal service -roviers, this agree$ent !oul +or$ the
contract #et!een the #usiness an the su--lier"
Dhen internal service areas are use, the service level agree$ent $ay
s-eci+y the stanar -rocessing ti$es an volu$es, an $ay inclue internal
charging arrange$ents"
0)8
In so$e cases, -articularly !hen internal areas are use, a etaile ocu$ent
$ay #e -re-are an agree, #ut over ti$e this $ay #e +orgotten an a !ie
range o+ res-onse ti$es an other results $ay occur"
In cases !here a service level agree$ent is in -lace, this shoul generally #e
revie!e -erioically an $onitore to ensure that it re$ains e++ective"
This -ro#le$ $ay #e -artially aresse #y incluing regular re-orting
!ithin the agree$ent itsel+"
2or e3a$-le, this coul inclue a $onthly re-ort containing the nu$#er o+
transactions -rocesse, the nu$#er o+ ne! custo$ers, an the -ercentage o+
transactions that !ere co$-lete !ithin the no$inate res-onse ti$es"
Service level agree$ents are also so$eti$es -oste +or tener, !ith service
-roviers su#$itting teners o+ +ees an other etails in res-onse to the
s-eci+ie re&uire$ents"
These arrange$ents are also use in other circu$stances such as
$aintenance agree$ents !ith e3ternal su--liers"
4.!.!. +omple)it$ & +ustomisation
The co$-le3ity o+ -roucts, an the a$ount o+ custo$isation -er+or$e +or
iniviual custo$ers, $ay have a signi+icant i$-act on -rocessing costs"
This issue a--lies to co$-uter syste$s an also to $anual -rocessing"
This issue shoul not alter the evelo-$ent o+ e++ective -roucts, or li$it
negotiations !ith -otential custo$ers"
=o!ever, this -ro#le$ $ay a++ect the general -rouct strategy an
o-erations o+ the #usiness"
2or e3a$-le, i+ one -rouct o-tion !as selecte #y 1,000 custo$ers, an a
secon -rouct o-tion !as selecte #y 1 custo$er, then this secon change
!oul ou#le the a$ount o+ -rogra$$ing !ork involve in evelo-ing an
a$inistration syste$"
The ti$e an cost involve in the evelo-$ent o+ an a$inistration syste$ is
e-enant on the co$-le3ity o+ the -rouct, an is not irectly a++ecte #y
volu$es"
0)1
Si$ilar issues $ay arise in the evelo-$ent o+ $anu+acturing +acilities"
The co$-le3ity o+ -rouct +eatures is one issue a++ecting the costs o+
a$inistration"
A -rouct that contains a large nu$#er o+ +eatures $ay re&uire aitional
-rogra$$ing ti$e in the evelo-$ent o+ an a$inistration syste$, an $ay
involve slo!er $anual -rocessing"
This -ro#le$ $ay #e aresse #y esigning -roucts !ith a si$-le range o+
e++ective o-tions, rather than a large nu$#er o+ co$-le3 an over<la--ing
+eatures"
Also, trans+erring e3isting arrange$ents +ro$ ol -roucts to u-ate
-roucts, an then iscontinuing the ol -rouct line, is generally -re+era#le
to continuing to o-erate t!o -rouct lines in -arallel"
This issue also a--lies to other areas o+ the #usiness, ranging +ro$ the
-rouction o+ $arketing $aterial to -re-aring accounts"

A $ore serious -ro#le$ arises !ith non<stanar arrange$ents !ith
custo$ers"
2or e3a$-le, a s-eci+ic arrange$ent $ay #e $ae +or a large custo$er !ho
trans+ers +ro$ a co$-etitorCs -rouct"
This $ay inclue a custo$ise arrange$ent !ith the custo$er, !hich coul
involve calculating +ees on a non<stanar #asis, such as a transaction<#ase
+ee rather than an asset<#ase +ee"
In these cases, the #usiness shoul generally atte$-t to use stanar +eatures
!here -ossi#le"
I+ a non<stanar arrange$ent is necessary to the -articular situation, then
this +eature can also #e ae to the -rouct line as a ne! stanar +eature"
The -otential +or these ty-es o+ -ro#le$s to evelo- $ay #e reuce i+ so$e
o+ the +ollo!ing situations are avoie"
Maintaining several -roucts that -er+or$ a si$ilar +unction, #ut are
i++erent in a large nu$#er o+ s-eci+ic +eatures"
0)6
An e3a$-le o+ this $ay involve continuing to sell an ol -rouct
line, !hen a ne! -rouct line ha #een evelo-e to re-lace the
-revious -rouct"
This situation can also arise !hen #usinesses are $erge !ith other
organisations"
Arranging s-eci+ic +eatures an alterations +or iniviual custo$ers,
that are outsie the stanar +eatures an o-tions that are inclue
!ithin the -rouct"
A signi+icant a$ount o+ -rogra$$ing an $anual -rocessing $ay
#e re&uire to i$-le$ent a $inor alteration that is $ae +or a
-articular custo$er"
7esigning -roucts that have co$-le3 +eatures !hen the sa$e result
coul #e achieve using a si$-ler set o+ -rouct o-tions"
In general, se-arate o-tions +or each -art o+ a -rouct leas to $ore
+le3i#le -roucts an si$-ler a$inistration, co$-are to selecting
+ro$ a long list o+ overla--ing -rouct alternatives"
".). 2nformation Technology
In+or$ation technology is a $a9or e3-ense in $any #usinesses"
This inclues the cost o+ co$-uter har!are, co$-uter so+t!are, an
su--orting co$-uter syste$s"
In+or$ation technology is a ca-ital intensive inustry"
This is not al!ays recognise, as no -hysical ite$s are create uring the
so+t!are evelo-$ent -rocess"
=o!ever, co$$ercial so+t!are -ackages $ay have costs in the $illion ollar
range, !hile large so+t!are evelo-$ent -ro9ects $ay involve thousans o+
-eo-le an a ca-ital cost o+ 100 $illion ollars or $ore"
4.7.1. Elements of information te.nolog$
080
The three $a9or ele$ents o+ an in+or$ation technology in+rastructure are the
har!are, the syste$s su--ort o-erations, an the so+t!are"
/o$-uter har!are $ay #e a signi+icant #usiness e3-ense"
Avance$ents in co$-uter technology occur at a ra-i -ace, an co$-uters
$ay nee to #e re-lace every three or +our years"
This results in the e-reciation e3-ense o+ co$-uter e&ui-$ent #eing high,
in contrast to other e&ui-$ent such as $anu+acturing e&ui-$ent !hich $ay
have a $uch longer li+e s-an"
%3-enses are also involve in installing an con+iguring co$-uters, +i3ing
har!are an so+t!are -ro#le$s, an training an su--ort o+ syste$ users"
In $any cases, the on<going su--ort costs are a larger e3-ense than the
har!are -urchase itsel+"

In general, ho!ever, the largest co$-onent o+ the in+or$ation technology
costs relates to so+t!are syste$s"
These $ay #e so+t!are -ackages that are -urchase co$$ercially, so+t!are
syste$s that are evelo-e #y in<house tea$s, or so+t!are evelo-e #y
e3ternal -arties uner a evelo-$ent contract"
/o$-uter syste$s are also use !ithin #usiness o-erations +or inustrial
-rocess an $achine control, esign !ork such as engineering si$ulations
an gra-hic esign, an +or e$#ee $achinery control !ithin -roucts"
4.7.2. 7ses of omputer s$stems
/o$-uter syste$s are use +or a !ie range o+ -ur-oses !ithin a #usiness
o-eration"
The ter$ :In+or$ation technology; generally re+ers to co$-uter -rocessing
o+ #usiness<relate in+or$ation, !hile co$-uter syste$s in general are also
use +or a !ie range o+ other -ur-oses !ithin #usiness o-erations"
Ma9or uses o+ co$-uter syste$s !ithin #usiness $ay inclue the +ollo!ing
areasE
081
A$inistration syste$s 5rocessing recei-ts, $aking -ay$ents,
issuing state$ents, an $aintaining
recors" This generally involves a large
ata#ase o+ in+or$ation, together !ith
-rocessing +unctions"
Business in+or$ation syste$s Syste$s +or re-orting -rouction statistics,
#uget an +inancial etails, sales an
$argin trens, an so on
7esign syste$s (ra-hic esign, engineering $oelling, etc"
5ersonal co$-uter syste$s So+t!are +or -roucing ocu$ents,
-roucing $arketing -resentations, analysis
o+ +igures +or such -ro9ect -ro+ita#ility, ne!
-rouct costs, etc"
Manu+acturing syste$s 5rouction $anage$ent, inventory control,
-rocess an $achinery control, costs
analysis, an so on"
Marketing syste$s Measuring -rouct -ro+ita#ility,
eter$ining custo$er -ro+iles, an
contacting custo$ers"
Dithin -roucts %$#ee control o+ $achinery, sales o+
so+t!are evelo-$ents"
7ata 5rouct s-eci+ications, custo$er . contract
etails, technical in+or$ation such as
$aterials in+or$ation use in engineering
esign"
So$e #usinesses use co$-uter syste$s in relation to the -roucts an
services the$selves, in aition to the a$inistration an o-erational
+unctions that $ay #e use"
2or e3a$-le, teleco$$unications #usinesses use co$-uter syste$s heavily,
!hile architectural an engineering esign also $akes e3tensive use o+
co$-uter technology"
7ata can #e valua#le, an a ata#ase o+ in+or$ation $ay +or$ the #asis +or
the entire #usiness itsel+"
082
2or e3a$-le, a $a- -rouction co$-any $ay use a ata#ase o+ geogra-hical
in+or$ation to generate $a-s o+ various escri-tions"
Asse$#ling this in+or$ation $ay involve consiera#le ti$e an e3-ense, an
this in+or$ation $ay #e the key +actor in ena#ling the #usiness to o++er
-roucts an services that co$-etitors coul not easily u-licate"
In situations such as this, the ata store !ithin the ata#ase $ay #e the
$a9or asset o+ the #usiness"
7ata#ases can #e co$-ile internally #y the #usiness, or in so$e cases can
#e -urchase +ro$ e3ternal sources"
4.7.3. #oft5are (evelopment
So+t!are evelo-$ent is a -ro9ect<#ase activity"
7evelo-$ent -ro9ects +ollo! the sa$e #asic ste-s as other esign an
construction -ro9ects, such as the evelo-$ent o+ a co$$ercial #uiling"
An initial esign -hase !oul result in a -ro9ect -lan involving a list o+ tasks
an a scheule o+ ti$e+ra$es"
2ollo!ing this, a etaile esign -hase $ay #e involve, +ollo!e #y the
-rogra$$ing tasks, an +inally testing, ocu$entation, an other tasks such
as ata conversions"
So+t!are evelo-$ent can #e consiere a ca-ital -ro9ect, an $ay #e
+une +ro$ a ca-ital allocation or +ro$ on<going cash +lo!"
In the case o+ general so+t!are evelo-$ent, such as re-orting an
a$inistration syste$s, the syste$ $ay a++ect the overall o-eration o+ the
#usiness, rather than generating a s-eci+ic cash +lo!, such as a ne! -rouct
evelo-$ent $ay -rouce"

In these circu$stances, valuing a so+t!are evelo-$ent using a $etho such
as a net<-resent<value a--roach $ay #e i++icult"
(eneral evelo-$ent -ro9ects $ay nee to #e revie!e on the #asis o+ their
overall i$-act on the o-erations o+ the #usiness"
083
4.7.4. Development approa.es
So$e #usinesses o-erate an internal so+t!are evelo-$ent area"
This area !oul generally #e +une on an ongoing cash +lo! #asis"
Alternatives inclue the use o+ e3ternal contract su--liers to evelo- s-eci+ic
syste$s"
In -ractice, $any syste$s are not o-tional an $ust #e co$-lete +or the
#usiness to continue o-erating"
2or e3a$-le, a ne! -rouct cannot #e +ully launche until an a$inistration
syste$ has #een !ritten to a$inister it"
/o$$ercial so+t!are -ackages are availa#le +or so$e co$$on #usiness
+unctions, such as accounts, a$inistration o+ so$e ty-es o+ -roucts, an
inventory $anage$ent syste$s"
=o!ever, in $ost cases a syste$ that involves the -roucts, services an
o-erations o+ the #usiness, $ust #e evelo-e as an iniviual -ro9ect"
4.7.5. +osts
So+t!are evelo-$ent $ay #e a signi+icant cost to the #usiness"
The sa$e issues a--ly to so+t!are evelo-$ent as other internal areas, such
as -rouct evelo-$ent an esign centres"
I+ -ro9ects are o-erate on the #asis o+ long<ter$ irections, rather than
s-eci+ic ti$e+ra$es, then the o-eration $ay #eco$e a -er$anent rain on the
cash +lo! o+ the #usiness an $ay not -rouce ite$s that are o+ -ractical use
to the #usiness"
An area that is too large to #e su--orte #y the #usiness o-erations $ay
reuce the -ro+ita#ility o+ the #usiness"
/onversely, insu++icient invest$ent in ne! syste$s $ay lea to high
-rocessing costs, restricte volu$es, &uality -ro#le$s, an i++iculty in
e++ectively $anaging an evelo-ing the #usiness"
080
4.7.!. /i)e( osts
So+t!are evelo-$ent is a +i3e cost"
Business volu$es $ay have a signi+icant i$-act o+ the average cost o+ the
evelo-$ent, !hen s-rea across the total nu$#er o+ custo$ers or
transactions"
Dhen a evelo-$ent has #een co$-lete, a so+t!are syste$ $ay have +e!
on<going varia#le costs, regarless o+ volu$es, a-art +ro$ the general costs
involve in o-erations such as sta++ costs"
7ue to this e++ect, a large so+t!are evelo-$ent $ay lea to a leverage
e++ect !ithin the #usiness"
,o! volu$es $ay result in a large loss, ue to the cost o+ the -ro9ect, !hile
high volu$es coul result in a large ro- in the average -rocessing cost o+
iniviual transactions"
In cases !here econo$ies o+ scale are availa#le through ca-ital -ro9ects, an
inustry $ay #eco$e concentrate a$ong a +e! o-erations, each !ith large
volu$es, e++icient -rouction or -rocessing, an lo! costs -er unit"
Although econo$ies o+ scale are o+ten consiere in relation to
$anu+acturing, a si$ilar situation $ay occur in so$e service inustries,
involving the evelo-$ent o+ co$-uter syste$s +or auto$ate -rocessing"
In a si$ilar !ay to a high ca-acity $anu+acturing +acility, a co$-le3
so+t!are syste$ $ay involve a large ca-ital cost, an $ay allo! e++icient
-rocessing o+ transactions !ith less $anual in-ut an lo!er costs -er
transaction that a -rocess that is -er+or$e using a la#our<intensive $anual
a--roach"
4.7.7. -aintenane
As !ith -hysical e&ui-$ent, so+t!are syste$s also re&uire $aintenance"
Scheule regular $aintenance is not generally involve, as !oul #e the
case !ith -hysical e&ui-$ent"
=o!ever, so+t!are $aintenance $ay involve +i3ing #ugs, $aking $inor
alterations, an aing -rocessing +unctions +or ne! -rouct +eatures"
08*
This generally involves $aking s$all changes in orer to allo! the syste$ to
continue o-erating e++ectively"
%3a$-les o+ $aintenance changes $ay inclue $oi+ications to a syste$ to
u-ate -rocessing ue to a change in govern$ent regulations"
,arger changes to syste$s $ay involve aing signi+icant ne! +unctions,
such as !hen a ne! -rouct line is launche"
Maintenance o+ so+t!are syste$s is not generally a $a9or e3-ense, !ith the
$a9or e3-enses #eing relate to ne! evelo-$ents"
4.7.8. 8ea( times
So+t!are evelo-$ent $ay involve a consiera#le -erio o+ ti$e"
A evelo-$ent o+ any signi+icance !oul usually re&uire a $ini$u$ o+
several $onths, an in so$e cases several years $ay #e involve #e+ore a
syste$ is +ully o-erational"
This can -resent a signi+icant -ro#le$ +or a #usiness"
2or e3a$-le, a ne! -rouct $ay #e esigne an $arketing in+or$ation $ay
#e -re-are, ho!ever an a$inistration syste$ to a$inister the -rouct $ay
not #e availa#le +or t!elve $onths"
In another e3a$-le, the #usiness $ay co$$ence o-erations in a ne! $arket,
!ithout the syste$s in+rastructure #eing availa#le to re-ort o-erational
results or $anage -rouction"
%3a$-les o+ these -ro#le$s $ay inclue co$$encing overseas sales, !here
transactions are conucte using +oreign currencies +or the +irst ti$e"
These situations are generally hanle !ith a co$#ination o+ changes to
e3isting syste$s, $anual -rocessing o+ -a-er +iles, an te$-orary syste$s
create to -er+or$ essential +unctions"
This can lea to high costs, slo! res-onse ti$es, an high error rates"
This $ay #e a -articular -ro#le$ !hen this #eco$es a -er$anent situation,
!ith ne! -roucts #eing evelo-e in a cycle that is ahea o+ the syste$s
evelo-$ent"
08)
7elaying -roucts !oul not #e an e++ective solution to this -ro#le$, as
o--ortunities $ay #e lost an the #usiness $ay +all #ehin co$-etitors"
The -ro#le$s that can arise in these situations $ay #e reuce though so$e
o+ the +ollo!ing ste-s"
Hsing several s$all syste$s !ith syste$ links, rather than a single
large syste$"
/are+ully $anaging te$-orary arrange$ents to ensure the so$e o+
the -otential -ro#le$s o not occur"
%nsuring that syste$s are esigne +or +le3i#le o-eration an
contain structures an +acilities that !oul ena#le +uture changes to
#e $ae !ithout e3cessive i++iculty"
Dhere -ossi#le, allocating a large nu$#er o+ resources to a -ro9ect
+or a short -erio o+ ti$e to ena#le the -ro9ect to #e co$-lete
!ithin a short ti$e +ra$e" This $ay involve concentrating resources
on a single -ro9ect +or a -erio o+ ti$e, rather than $ulti-le -ro9ects,
using contract sta++, or arranging a syste$ evelo-$ent #y an
e3ternal contract evelo-$ent #usiness"
4.7.9. Distribute( & +entralise( omputing
The structure o+ large co$-uter +acilities +alls into t!o #roa categories"
/entralise co$-uter syste$s use a central $ain+ra$e syste$, connecte to a
nu$#er o+ ter$inals at i++erent locations"
These syste$s $ay have avantages !ith security, an lo!er -er<ter$inal
su--ort costs !hen a large nu$#er o+ access -oints are involve"
This a--roach is co$$only use in situations !here the sa$e -rocessing is
-er+or$e at a large nu$#er o+ se-arate locations, such as #anking"
Main+ra$e syste$s are also use !hen very large volu$es o+ ata storage
are involve"
7istri#ute syste$s use -ersonal eskto- co$-uters, or co$-uters
su--orting a li$ite area o+ o-erations"
088
These co$-uters are generally connecte together #y a net!ork o+ so$e
kin"
This a--roach generally su--orts $ore co$-le3 -rocessing at the iniviual
co$-uter, an is use+ul !hen a range o+ i++erent +unctions are -er+or$e in
i++erent areas"
Also, har!are costs +or istri#ute syste$s $ay #e lo!er than +or
centralise syste$s in the case o+ s$all an $eiu$ si@e o-erations"
Although each situation $ay vary, an o-eration !ith less than 100 se-arate
ter$inals or co$-uters $ay #e $ore cost<e++ective using a net!ork
arrange$ent o+ -ersonal co$-uters that using a central syste$"
In cases !here several hunre ter$inals are involve, -er+or$ing si$ilar
o-erations, a central $ain+ra$e syste$ $ay #e $ore suita#le"
".-. 6anufacturing
Manu+acturing involves -roucing -hysical ite$s +ro$ ra! $aterials"
This inclues a !ie range o+ i++erent activities, ranging +ro$ #aking #rea
to constructing aircra+t"
Manu+acturing is a signi+icant section o+ the econo$y"
Many #usinesses o-erate -urely as $anu+acturing o-erations"
In other cases, a #usiness $ay have a $anu+acturing o-eration !ithin its
structure, an also -er+or$ a range o+ other activities as !ell"
Many o+ the issues involve in $anu+acturing also a--ly to other #usiness
activities, such as the -ri$ary -rouction activities o+ $ining an agriculture"
4.8.1. Elements of -anufaturing
4.8.1.1. +apital osts
Manu+acturing is a ca-ital<intensive #usiness"
081
Manu+acturing +acilities an e&ui-$ent $ay have a high ca-ital cost"
The ca-ital re&uire$ents o+ the #usiness can #e +une !ith e#t or !ith
e&uity +uns"
Alternatively, $any ite$s o+ e&ui-$ent can #e lease"
,easing $ay #e arrange through #anks, leasing co$-anies, an in so$e
cases the e&ui-$ent $anu+acturer the$selves"
This a--roach $ay reuce the irect ca-ital re&uire$ents o+ the #usiness, an
$ay #e -articularly suita#le +or start<u- an e3-aning o-erations"
,easing is a secure +or$ o+ lening, an arranging an e&ui-$ent lease $ay
#e easier than raising orinary e#t in so$e cases"
Manu+acturing is an asset<#ase activity, rather than a cash +lo! or -ro9ect<
#ase #usiness"
%&ui-$ent an +acilities eteriorate over ti$e, an have a li$ite use+ul
!orking li+e"
Regular reinvest$ent in ne! e&ui-$ent an +acilities is necessary to allo! a
$anu+acturing o-eration to continue -roucing ite$s e++iciently"
4.8.1.2. Depreiation
7e-reciation is a $a9or e3-ense in $any $anu+acturing o-erations"
7e-reciation re-resents the reuction in the value o+ the e&ui-$ent an
+acilities over a -erio o+ ti$e"
7e-reciation oes not re-resent a cash transaction, ho!ever it oes re-resent
a loss o+ net assets"
A $anu+acturing o-eration $ay generate a -ositive cash +lo!, an yet still
recor a loss"
2or e3a$-le, the #usiness $ay generate a net cash +lo! inco$e o+ G1* -er
year, an have a e-reciation e3-ense o+ G20"
086
In this case, cash !oul #e +lo!ing into the #usiness at the rate o+ G1* -er
year, #ut the value o+ the e&ui-$ent !oul #e eclining at the rate o+ G20 -er
year"
This !oul result in a net loss o+ G* -er year"
This issue highlights the i$-ortance o+ -rouction volu$e an ca-acity
utilisation to a $anu+acturing o-eration"
The e-reciation e3-ense is a constant e3-ense !ith each ne! -erio,
ho!ever the inco$e o+ the o-eration is e-enant on the level o+ -rouction
an sales"
In the case o+ orinary #usiness activity, i+ no activity occurre an no
-ay$ents !ere $ae uring a ti$e -erio, then no loss or -ro+it !oul #e
recore"
=o!ever, in the case o+ a $anu+acturing o-eration, a situation involving no
activity, no inco$e, an no e3-enses, !oul result in a continuous loss #eing
recore"
This !oul occur ue to the +act that the value o+ the e&ui-$ent an +acilities
continually eclines as ti$e -asses"
In these situations, a $ini$u$ level o+ -rouction $ay #e necessary to reach
a #reak<even or -ositive -ro+it level"
In the case o+ so$e other ca-ital<intensive #usinesses, that $ay involve large
invest$ents in assets such as -ro-erty, +inancial assets or $ines, this issue
oes not arise, as the assets o not e-reciate in value"
In the case o+ $anu+acturing o-erations, #oth the cash +lo! accounts an the
accounting<#ase analysis $ay have i$-ortant signi+icance +or the #usiness"
4.8.1.3. :olumes
(eneral #usiness analysis eals !ith +inancial +igures"
This $ay inclue inco$e an e3-enses, asset an e#ts, $argins, an so on"
In the analysis an $anage$ent o+ $anu+acturing, the nu$#er o+ ite$s
-rouce is also i$-ortant, in aition to +inancial +igures"
010
5rouction $anage$ent eals !ith the volu$e o+ -roucts that is create an
the volu$e o+ ra! $aterials that is use uring a -erio o+ ti$e"
In turn, these volu$es a++ect the cost structure an -ro+ita#ility o+ the
#usiness"
Si$ilar issues coul also a--ly in so$e other #usiness situations"
2or e3a$-le, the nu$#er o+ ite$s sol in a retail o-eration, an the nu$#er
o+ hours #ille #y a service #usiness, are #oth volu$e<#ase +igures that $ay
a++ect the +inancial structure an results o+ the #usiness"
4.8.1.4. /i)e( & variable osts
Manu+acturing costs $ay #e #roken into t!o categories"
+i%ed costs
2i3e costs o not vary !ith the level o+ -rouction"
These inclue #uiling rents, e-reciation, an general costs such as
$arketing an a$inistration e3-enses"
2i3e costs a--ly to a -erio o+ ti$e, an are not a++ecte #y the volu$e o+
-rouction"
aria"le costs
'aria#le costs are costs that a--ly to the -rouction o+ s-eci+ic ite$s"
This $ay inclue ra! $aterials, an other costs such as +uel an electricity"
'aria#le costs a--ly to the volu$e o+ -rouction, an are not a++ecte #y
ti$e -erios"
-otal costs
The total costs o+ a #usiness uring a -erio are a co$#ination o+ the +i3e
costs an the varia#le costs"
011
The +i3e costs are s-rea across the volu$e o+ -rouction that occurre
uring a ti$e -erio"
=igh -rouction volu$es result in the +i3e costs #eing s-rea across a large
nu$#er o+ ite$s, !hich leas to lo! total cost -er unit"
Proportion of fi%ed & varia"le costs
The -ro-ortion o+ +i3e to varia#le costs $ay #e in+luence #y a range o+
+actors, such as the level o+ $echanical auto$ation involve in a -rouction
-rocess"
A -rocess involving high ca-acity +acilities an e&ui-$ent $ay generally
have a high +i3e cost an lo! varia#le costs"
In these cases, the #usiness $ay e3-erience a large leverage to rising or
+alling sales"
In contrast, a -rocess than involve a large -ro-ortion o+ $anual in-ut $ay
have lo! +i3e costs #ut high varia#le costs"
In these cases, the leverage to rising or +alling sales $ay #e lo!er"
4.8.1.5. 3rofit & volumes
=igh volu$es $ay increase the -ro+it o+ a $anu+acturing o-eration in t!o
!ays"
The nu$#er o+ transactions is larger in the case o+ high volu$es than lo!
volu$es"
Also, the -ro+it $argin +or each iniviual transaction is higher in the case o+
high volu$es, ue to the +i3e costs #eing s-rea across a large nu$#er o+
units"
,o! volu$es -rouce lo! -ro+its or losses ue to the o--osite case o+ the
sa$e t!o e++ects"
012
4.8.1.!. Eonomies of sale
In general, the cost -er unit o+ -rouction ecreases as the ca-acity o+ the
-rocess is increase"
2or e3a$-le, a -rinting $achine that -rints 10,000 -ages -er hour !oul
generally involve a lo!er cost -er -age than a $achine that -rinte 100 -ages
-er hour"
Builing high ca-acity +acilities an -urchasing high ca-acity e&ui-$ent
$ay have a signi+icant ca-ital cost"
=o!ever, this $ay also allo! the cost -er unit to #e reuce"
Many $anu+acture ite$s are sol in o-en $arkets against co$-etitors !ith
si$ilar -roucts an -rouction +acilities"
In these situations, the $anu+acturer !ith the lo!er cost -er unit can o++er
lo!er sale -rices an $ay receive a large volu$e o+ sales"
This cash +lo! $ay #e reinveste in higher ca-acity +acilities, !hich $ay
lea to a re-eating cycle o+ e3-aning sales an ca-acity, an +alling costs
-er unit"
This e++ect results in $any inustries #eco$ing concentrate a$ong a +e!
$anu+acturers -roucing large volu$es at lo! costs -er unit"
Ane a--roach $ay involve an assu$-tion that the cost -er units +alls at a
constant rate each ti$e that ca-acity is ou#le"
2or e3a$-le, one rule<o+<thu$# that $ay #e use !ithin $anu+acturing, $ay
involve costs -er unit +alling #y 00L each ti$e that ca-acity !as ou#le (>>
check)"
Hner this assu$-tion, the +all in cost<-er<unit !hen ca-acity !as increase
+ro$ *0 units to 100 units !oul #e the sa$e -ercentage +all that !oul
occur !hen ca-acity !as increase +ro$ *,000 units to 10,000 units"
The a++ect can #e illustrate in the +ollo!ing gra-h, !hich sho!s the ecline
in cost<-er<unit that $ay occur !ith large<ca-acity +acilities co$-are to
s$all<ca-acity +acilities"
This issues relates to #oth the volu$e o+ -rouction +ro$ a -articular +acility,
an the si@e o+ the -rouction +acility itsel+"
013
Cost 3er 7nit
"
".1
".2
".3
".4
".5
".!
".7
".8
".9
1
" 1" 2" 3" 4" 5" !" 7" 8" 9" 1""
1olume
C
o
s
t
2igure 2
4.8.1.7. +apait$
/a-acity re+ers to the nu$#er o+ ite$s that can #e -rouce !ithin a
-articular -erio o+ ti$e"
Hner<ca-acity occurs !hen the -rouction +acilities can only -rouce a
li$ite volu$e o+ out-ut !ithin a -erio o+ ti$e"
Aver<ca-acity occurs !hen a large an e3-ensive +acility has #een #uilt, !ith
high -rouction ca-acity, that is not +ully utilise"
4.8.1.7.1. 7n(er*apait$
Hner<ca-acity $ay #e a -ro#le$ in several circu$stances"
010
I+ other areas o+ the #usiness have a higher ca-acity than a -articular +acility,
then the other areas o+ the #usiness $ay not #e a#le to o-erate at +ull
ca-acity, ue to the li$itations o+ that +acility"
This $ay result in other areas o-erating at -artial ca-acity, !hich $ay
increase costs<-er<unit as the +i3e costs !oul #e s-rea across a s$all
nu$#er o+ ite$s"
An e3a$-le o+ this $ay #e a -o!er su--ly +acility"
In so$e o-erations, such as $ining activities in re$ote areas, the -rocessing
-lant inclues a se-arate -o!er generation +acility to generate electrical
-o!er +or the $ain +acility"
This coul #e -o!ere #y coal, oil, or natural gas +or e3a$-le"
I+ the -rouction +acilities !ere e3tene, the -o!er generation -lant $ay
not have su++icient ca-acity to -o!er the e3-ane +acilities"
In this case, the uner<ca-acity o+ the -o!er generation !oul -revent the
+acility +ro$ o-erating at +ull ca-acity"
Another e3a$-le $ay involve a success+ul -rouct !ith a !ie istri#ution
channel, !here the #usiness i not have su++icient -rouction ca-acity to
$eet the e$an +or the -rouct"
Hner<ca-acity $ay also cause -ro#le$s !ith co$-eting in o-en $arkets"
A #usiness !ith li$ite -rouction ca-acity !oul generally e3-erience
higher -er<unit costs than other $anu+acturers"
In these circu$stances, it $ay #e i++icult +or the #usiness to co$-ete
e++ectively in a -articular $arket"
5ro#le$s !ith uner<ca-acity coul #e aresse in several !ays"
These $ay inclue the +ollo!ing a--roaches"
/onstructing ne! +acilities or -urchasing higher<volu$e e&ui-$ent"
I$-roving -rouction $anage$ent an re$oving #ottlenecks in
e3isting +acilities, to ena#le a higher volu$e o+ -rouction to #e
achieve +ro$ e3isting +acilities"
01*
=iring te$-orary +acilities"
Arranging -rouction #y other #usinesses on a contract #asis"
5urchasing $aterials or -arts +ro$ other #usinesses !here the
#usiness oes not have su++icient ca-acity to -rouce the ite$s
internally"
4.8.1.7.2. Overapait$
Averca-acity occurs !hen a +acility has #een #uilt that has a higher ca-acity
than the unerlying e$an +or the -rouct"
This is a se-arate issue to an e3isting +acility #eing unerutilise, although
the net result $ay #e si$ilar"
Averca-acity can occur !hen o-ti$istic assu$-tions !ere $ae regaring
the e$an +or a -rouct, an !here the esign ca-acity o+ the +acility is
higher than the $arket e$an +or the -rouct"
Averca-acity can also occur !hen a +acility is #uilt !ith aitional ca-acity
to allo! +or +uture e3-ansion, ho!ever this e3-ansion oes not occur in the
$eiu$ ter$"
2or e3a$-le, constructing a $a9or +acility or -urchasing a large ite$ o+
e&ui-$ent is generally a $a9or transaction"
%&ui-$ent $ay #e rene!e every 10 or 1* years, !hile large -rouction
+acilities $ay o-erate +or hal+ a century or $ore"
7uring ti$es o+ high gro!th, it is co$$on to #uil a +acility !ith larger
ca-acity than current nees, to allo! +or +uture gro!th, an to reuce the risk
that -ro#le$s !ith uner<ca-acity $ay arise in the +uture"
=o!ever, i+ this is one at the -eak o+ a -erio o+ sales gro!th, then a +acility
!ith a large ca-acity $ay #e #uilt an $ay never #e +ully use"
Dhen a +acility has e3cess ca-acity, the e-reciation e3-ense an the ca-ital
cost $ay not #e o++set #y the level o+ -rouction, an -oor -ro+ita#ility or
loss<$aking o-erations $ay occur"
Averca-acity $ay #e aresse in so$e o+ the +ollo!ing !ays"
01)
5er+or$ing contract $anu+acturing +or other #usinesses"
%3-aning other +acilities to $atch the ca-acity o+ the +acility !ith
the e3cess ca-acity"
Increasing $arketing e++orts to increase sales, such as e3-aning
into overseas $arkets"
/reating ne! lines o+ -roucts to o-erate in ne! $arkets, an to use
a larger -ro-ortion o+ the availa#le ca-acity"
/losing o-erations !ithin -arts o+ a +acility to reuce on<going
e3-enses"
4.8.1.7.3. +losing failities
2acilities $ay #e close either te$-orarily or -er$anently !hen there is
insu++icient e$an +or -roucts, or !hen $arket -rices are lo!, resulting in
the +acility #eing una#le to o-erate at a -ositive -ro+it level"
/losing +acilities so$eti$es occurs in $ining activities uring -erios o+ lo!
$arket -rices"
This involves ceasing o-erations, returning contract an hire e&ui-$ent, an
-lacing the $ine on a :care an $aintenance; #asis"
The -rocess o+ closing or reo-ening a $ine $ay involve consiera#le
e3-ense, an this is usually one uring a -erio o+ sustaine lo! -rices"
The $aintenance o-erations $ay involve a s$all on<going e3-ense to ensure
that e&ui-$ent is -ro-erly store, an that the +acilities re$ain in a sta#le
conition"
A si$ilar -rocess can #e a--lie to -arts o+ inustrial -lants"
This -roceure $ay #e less co$$on !ith inustrial -lants than !ith $ines,
as the value o+ the $ine ore oes not ecline over ti$e, ho!ever the value o+
inustrial e&ui-$ent an +acilities +alls continuously"
The accounting e-reciation e3-ense is generally s-rea across the esti$ate
!orking li+e o+ the e&ui-$ent"
018
=o!ever, this assu$es that the e&ui-$ent !ill #e use at a stanar rate o+
-rouction"
In reality, the value o+ the e&ui-$ent $ay ecline at a lo!er rate !hen
-rouction is not occurring"
This is ue to the +act that the $a9ority o+ the ecline in value $ay occur ue
to !ear<an<tear, rather than -urely ue to the -assage o+ ti$e"
/losing +acilities $ay involve reucing the e3-enses relating to lighting an
heating, recovering ca-ital hel in ra! $aterials stocks, reucing salary costs
involving -er$anent e$-loyees, an so on"
4.8.1.8. Te.nolog$
Technology is a signi+icant issue in $anu+acturing"
In $ost $arkets, co$-eting $anu+actures o++er -roucts that $ay #e si$ilar
to the #usinessCs -roucts"
Although e++ective $anage$ent o+ the #usiness an the +acilities $ay have a
signi+icant i$-act on costs, the $a9or i++erences in costs $ay arise +ro$
econo$ies o+ scale, an +ro$ technology"
A $anu+acturer than oes not regularly re<invest in ne! technology an
+acilities $ay +in that it graually looses $arket share to co$-etitors"
Technology involves the ty-e o+ e&ui-$ent that is use, co$-uter har!are
an so+t!are syste$s, the construction o+ +acilities, an uni&ue
$anu+acturing -rocesses"
These issues a--ly to iniviual $achines, an also to the construction o+
entire $anu+acturing -lants"
0ni)ue technolog*
Hni&ue technology $ay involve a -rocess +or -roucing ite$s using less ra!
$aterials than -revious -rocesses, or it $ay allo! larger volu$es o+ higher
&uality ite$s to #e -rouce using e3isting resources than -revious
-rocesses"
011
%3a$-les $ay inclue a ne! ty-e o+ -lastic, !hich $ay ena#le -lastic -arts
to #e -rouce using less $aterials an !ith higher o-erating -er+or$ance
than -revious -rocesses"
Technology can #e evelo-e in<house #y the #usiness, or license +ro$
other -arties"
An e3a$-le o+ this situation $ay occur !hen a -rocess is use !ithin an
overseas $arket, an is license #y a $anu+acturer +or use !ithin a local
region"
0pdated e)uipment
The technology involve in $achinery avances as ti$e $oves #y"
A ne! $achine $ay use less ra! $aterials, have a lo!er +ault rate, an $ay
have a higher -rouction ca-acity than a -revious version o+ a si$ilar
$achine"
This issue is aitional to the e++ect o+ re-lacing !orn<out e&ui-$ent !ith
ne! e&ui-$ent"
H-ating e&ui-$ent $ay lea to a signi+icant i$-rove$ent in e++iciency,
-articularly !hen this is #alance through the +ull -rouction -ath, rather
than -rouction #eing li$ite #y one stage in the -rocess"
-echnolog* within products
Technology can also #e inclue !ith the +inal -roucts"
This $ay inclue ne! $aterials, s$aller $anu+acturing tolerances,
e$#ee co$-uter chi-s an so on"
4.8.1.9. +omputer .ar(5are & soft5are
/o$-uter har!are an so+t!are +or$ a $a9or co$-onent o+ large<scale
$anu+acturing"
This $ay involve -rocess control, an -rouction $anage$ent"
016
5rocess control involves co$-uterise an other har!are control o+
$achinery an +acilities"
This is one using co$-uter -rocessing to control te$-eratures an
-ressures, +lo! rates, -rouction rates an so on"
%nsuring that the -rocess control e&ui-$ent is o-erating e++ectively $ay
have a signi+icant i$-act on -rouction ca-acity an e++iciency"
Also, in so$e $anu+acturing o-erations, -rocess control e&ui-$ent coul #e
installe to increase -rocessing ca-acity, reuce error rates an $aterials
usage, an allo! the -rouction -rocess to #e $ore e++ectively $anage"
5rouction $anage$ent so+t!are $ay involve scheuling -rouction runs,
analysing $argins an -rouct $i3es, $anaging inventory levels an so on"
%++ective so+t!are +or -er+or$ing these +unctions $ay i$-rove the
-rouction rate an -ro+ita#ility o+ a $anu+acturing -lant, -articularly !hen a
large nu$#er o+ i++erent -roucts are involve"
4.8.1.1".-anufaturing vs. Design
In the case o+ s$all enter-rises an long<ter$ -roucts, the cost o+ the initial
-rouct esign $ay not #e a signi+icant cost o+ the total #usiness o-eration"
=o!ever, in the case o+ short -rouct li+e cycles, or !hen large ca-ital costs
are involve in the esign -rocess, the #usiness coul e++ectively #e s-lit into
t!o se-arate o-erations"
This $ay involve a -rouct esign centre, an a se-arate $anu+acturing
o-eration"
5rouct esign is a -ro9ect<#ase activity, !hile $anu+acturing is a
continuous activity"
In ter$s o+ revie!ing the +inancial structure o+ the #usiness, a clearer -icture
$ay so$eti$es e$erge i+ these t!o activities are se-arate"
This can #e i$-le$ente #y se-arating the costs o+ each area, an creating
licence +ees that are -ai +ro$ the $anu+acturing o-eration to the esign
centre"
060
This $ay highlight !hether the t!o areas are in -ro-ortion to each other, or
!hether too $uch or too little ca-ital is investe in the esign -rocess"
4.8.2. T$pes of manufaturing
Manu+acturing occurs in various +or$s"
This $ay inclue so$e o+ the +ollo!ing issues
4.8.2.1. #tan(ar( pro(uts vs. single or(er
So$e $anu+acturing o-erations -rouce a stanar set o+ -roucts, !hich
$ay #e u-ate +ro$ ti$e to ti$e"
Ather #usinesses $ay o-erate on a single<orer #asis"
In these cases, ite$s are -rouce s-eci+ically +or clients, an the esign o+
an ite$ $ay #e i++erent in each -rouction run"
2or e3a$-le, o-erations such as -rinting an creating custo$ise ite$s $ay
involve a i++erent esign !ith each -rouction run"
4.8.2.2. +ontinuous vs. bat. pro(ution
Manu+acturing -rocesses $ay o-erate continuously, or +or se-arate -erios
o+ ti$e"
2or e3a$-le, the $ass -rouction line that !as create to #uil the Moel T
2or !as the +irst e3a$-le o+ continuous -rouction in $oern ti$es"
/ontinuous -rouction is generally the $ost e++icient !ay to -rouce ite$s
in high volu$e, at lo! cost -er unit an !ith lo! error rates"
Also, continuous -rouction is necessary in so$e activities such as electricity
generation, oil re+ining, an so on"
Batch -rouction is use !hen a large nu$#er o+ i++erent -roucts are
$ae, !hen volu$es are li$ite, an !hen custo$ ite$s are -rouce"
061
This -rocess $ay involve setting u- e&ui-$ent, arranging su--lies,
-er+or$ing the actual -rouction run an then is$antling various structures"
The -rouction o+ nuts, #olts an other +asteners $ay #e an e3a$-le o+ this,
!hen in so$e cases several thousan i++erent -roucts are carrie #y the
$anu+acturer"
4.8.2.3. -anual & -e.anial 3ro(ution
5rouction generally involves a co$#ination o+ $anual activity an
$achinery o-erations"
So$e s$all enter-rises use -urely han<$ae -rouction $ethos"
=an cra+ts are an e3a$-le o+ this situation"
In the case o+ large scale -rouction, a $anu+acturing -lant $ay #e highly
auto$ate, !ith the entire -rouction -rocess #eing -er+or$e #y continuous
$echanical -rocess, an hu$an in-ut #eing li$ite to $onitoring -rocess
-ara$eters to ensure than -ro#le$s o not arise"
5o!er generation stations $ay o-erate on this #asis"
As a general rule, the -ro-ortion o+ $echanical o-eration, co$-are to the
level o+ $anual activity involve, is higher in large<scale +acilities than !ith
s$all<scale +acilities"
=igh levels o+ $echanical -rouction $ay lea to high ca-ital an +i3e
costs, !ith lo! varia#le costs"
Manual -rouction $ay involve lo! ca-ital costs an a high -ro-ortion o+
varia#le costs"
In general, a high level o+ $echanical -rouction leas to lo!er total costs,
higher volu$e ca-acity, an lo!er +ault rates than $anual -rouction"
Manual -rouction is suita#le +or lo! volu$es an custo$ise ite$s"
/o$-le3 asse$#ly generally involves $anual -rocesses in s$aller
enter-rises, an auto$ate -rocesses in large<scale $anu+acturing"
Mechanical -rouction is suita#le +or high volu$es an +or situations !here
accuracy an tolerances are critical"
062
4.8.3. 3ro(uts & pro(ution
4.8.3.1. 3ro(ut (esigns
The esign o+ the -roucts that are $ae !ithin a $anu+acturing o-eration
$ay co$e +ro$ several sources"
This $ay inclue so$e o+ the +ollo!ing"
5roucts evelo-e internally !ithin an integrate o-eration"
5roucts evelo-e !ithin the #usiness #y a se-arate esign centre"
5rouct esigns license +ro$ e3ternal -arties"
5roucts $ae accoring to s-eci+ications su--lie #y outsie
-arties, uner a contract $anu+acturing arrange$ent that involves
-roucing ite$s +or other #usinesses"
5rouct $ae on a custo$, single<orer #asis" 2or e3a$-le, -rinting
o-erations generally o-erate in this !ay"
In the case o+ -rouct esigns an technology license +ro$ other -arties,
license +ees !oul usually #e -ai"
This $ay involve a +i3e -ay$ent -er -erio, an a$ount +or each ite$
-rouce, or so$e other a--roach"
4.8.3.2. 3ro(ution output
The out-ut +ro$ a -rouction -rocess $ay #e generate +or a range o+
-ur-oses"
This coul inclue so$e o+ the +ollo!ing -ur-oses
Ite$s -rouce +or sale #y the #usiness itsel+ to custo$ers or
istri#utors"
063
Ite$s -rouce +or sale into o-en $arkets"
Ite$s -rouce on #ehal+ o+ other #usinesses, uner a contract
$anu+acturing arrange$ent
Single ite$s -rouce +or s-eci+ic custo$ers, or custo$ise
-rouction runs accoring to a custo$er orer"
4.8.4. 'nal$sis of a manufaturing operation
Analysis o+ a $anu+acturing o-eration involves the general #usiness issues o+
$argins, returns, cash +lo! an ca-ital structure"
=o!ever, $anu+acturing analysis $ay #e -articularly concerne !ith assets,
the volu$es o+ $aterials -rouce, an the se-aration #et!een the +i3e an
varia#le costs o+ -rouction"
/osts an in-uts to a -rouction -rocess $ay inclue the +ollo!ing ite$s"
Materials
%lectricity
2uel
,a#our costs
7e-recation o+ e&ui-$ent
2uning is generally a se-arate issue +ro$ the o-erational structure o+
$anu+acturing, an the values o+ e&uity, e#t an interest costs are not
inclue !ithin a -rouction or $argin analysis"
In the case o+ lease e&ui-$ent, the lease -ay$ents coul #e s-lit into an
interest co$-onent, an a se-arate co$-onent that coul #e inclue as a
e-reciation +igure"
060
4.8.4.1. 3ro(ution anal$sis
5rouction analysis is concerne !ith the volu$es o+ ite$s -rouce, an
the volu$es o+ ra! $aterials use"
5rouction analysis relates to activity that occurre over a -erio o+ ti$e,
rather than static +igures such as asset values that a--ly at a -articular ate"
In conte3t o+ -rouction analysis, la#our costs inclues -ay$ents to
e$-loyees involve in -rouction, an oes not inclue sta++ costs relating to
other #usiness activities such as $arketing or a$inistration"
5rouction analysis $ay involve t!o $a9or areas"
These $ay inclue the +ollo!ing -oints"
The level o+ -rouction in co$-arison to -lant ca-acity an +i3e
costs"
The e++iciency o+ -rouction, in ter$s o+ the nu$#er o+ in-uts
re&uire to generate a +inishe -rouct"
5rouction re-orts in large $anu+acturing o-erations $ay inclue a large
volu$e o+ in+or$ation an statistics"
This coul inclue -rouction volu$es o+ +inishe goos, !ork in -rogress,
su--lies use, $argins, an +igures +or various ti$e -erios"
Monthly re-orts $ay inclue +igures +or recent $onths, tren changes, totals
over longer -erios, an co$-arisons !ith the sa$e -erio in -revious years"
Although a !ie range o+ +igures, statistics an $argins coul #e calculate
an re-orte, so$e o+ the +ollo!ing ite$s $ay re-resent so$e o+ the $a9or
issues"
4.8.4.1.1. 3ro(ution tren(s
Although -rouction levels $ay have a large i$-act on costs, the level o+
-rouction is generally set #y issues such as custo$er e$an, $arketing
activities, an u-ating o+ -rouct lines"
5rouction $anage$ent $ay involve revie!ing tren changes in e++iciency"
06*
This $ay inclue the a$ount o+ $aterials use to -rouce ite$s, the nu$#er
o+ e$-loyees neee to su--ort a -articular -rouction level, an so on"
7eteriorating values +or these +igures $ay inicate that e&ui-$ent is
#eco$ing outate, that scheuling an shi+t $anage$ent coul #e
i$-rove, or that ne! -rouction -rocesses shoul #e i$-le$ente"
4.8.4.1.2. 3ro(ution levels
/a-acity utilisation re+ers to the volu$e o+ -rouction uring a -erio, in
co$-arison to the -lant ca-acity"
The ca-acity utilisation rate can #e calculate using the +ollo!ing +or$ula"
100
plant the of capacity design
produced items of number
n urilisatio capacity
2or e3a$-le, i+ a -lant ha a ca-acity o+ 20,000 units -er $onth, an
-rouction !as 1*,000 +or the -revious $onth, then the ca-acity utilisation
coul #e calculate using the +ollo!ing +igures"
100
20000
1*000
n utilisatio capacity
8*
4.8.4.1.3. 'vailabilit$
Availa#ility $ay also #e an i$-ortant -rouction $anage$ent issue, in
aition to ca-acity utilisation"
Dhile ca-acity utilisation is a $a9or +actor in eter$ining cash +lo! an
-ro+ita#ility, the volu$e o+ -rouction in the short ter$ $ay #e eter$ine
#y the level o+ custo$er orers"
Availa#ility re+ers to the -ercentage o+ ti$e that a +acility !as availa#le +or
use, !hether -rouction actually occurre or not"
06)
A lo! availa#ility rate $ay #e ue to +re&uent -rouction sto--ages ue to
!orn<out e&ui-$ent generating high +ault rates, shortages o+ ra! $aterials,
e&ui-$ent #reak<o!ns an so on"
Availa#ility is a -rouction $anage$ent issue, in contrast to ca-acity
utilisation, !hich $ay #e a !ier issue"
/a-acity utilisation $ay #e e-enant on creating -roucts that $eet !ith a
e$an +ro$ custo$ers, -er+or$ing e++ective $arketing activities, an
ensuring that the #usiness o-eration is e++icient an allo!s -roucts to #e
-rice co$-etitively"
A lo! availa#ility rate $ay lea to lo! ca-acity utilisation, an long elays
in +illing custo$er orers"
The availa#ility rate $ay #e calculate using the +ollo!ing +or$ula"
100
production potential of hours tota
use for availabile hours
rate ty availabili
4.8.4.1.4. -aterials usage
The volu$e o+ a $aterial use to -rouce a -rouct coul #e calculate using
the +ollo!ing a--roach
produced items of number
used material of volume
item per usage materials
2or e3a$-le, i+ 8 kilogra$s o+ -lastic !ere use to -rouce 1000 -lastic
#ottles, then the $aterials usage coul #e calculate using the +ollo!ing
a--roach"
1000
8
item per usage materials
$g .008 0
068
I+ the tren in $aterials usage graually rises over a long -erio, then this
$ay suggest that the e&ui-$ent is #eco$ing less e++icient, !ith increase
!astage an +ault rates, an that re-lace$ent e&ui-$ent $ay #e necessary"
A si$ilar calculation coul #e a--lie to the a$ount o+ electricity or +uel
use #y -rouction -rocesses"
2or e3a$-le, in the case o+ electricity, this coul #e calculate using the
+ollo!ing a--roach
produced items of number
used electricty of amount
item per usage y electricit
In this case, electricity usage !oul re+er to -rouction e&ui-$ent only, an
not to general usage such as lighting"
2uel an electricity usage -er ite$ -rouce coul also #e use to asses any
ecline in e&ui-$ent o-erating -er+or$ance"
A rising +igure over ti$e $ay suggest that e&ui-$ent !as #eco$ing less
e++icient an !as ue +or re-lace$ent"
These calculations a--ly to varia#le costs, !here each in-ut irectly relates
to the -rouction o+ a single unit"
,a#our costs -er unit coul also #e calculate using the sa$e a--roach"
2or e3a$-le, the +ollo!ing +or$ula coul #e use"
produced items of number
(or$ed hours of number
usage labour
2or e3a$-le, i+ a total o+ 1200 $an<hours !ere !orke uring a -erio, an
1*0000 ite$s !ere -rouce, then the +ollo!ing calculation !oul a--ly
1*0000
1200
usage labour
061
item per hours labour . 001 0
A graually rising tren $ay inicate that e&ui-$ent !as #eco$ing less
e++icient an that -rouction !as #eco$ing la#our<intensive, or that sta++
levels !ere unnecessarily high"
=o!ever, this calculation coul only #e a--lie !hen the nu$#er o+ hours
!as irectly relate to the nu$#er o+ ite$s -rouce"
In -ractice, costs relating to -er$anent e$-loyees $ay #e a largely +i3e, not
a varia#le cost, !hile costs relating to overti$e shi+ts, te$-orary, an
contract sta++ $ay #e varia#le costs"
4.8.4.1.5. Bastage an( faults
The e++iciency o+ a $aterial usage coul #e calculate using the +ollo!ing
+or$ula
100
used material of volume
products finished in material of volume
efficiency usage materials
In the case o+ $ulti-le i++erent -roucts, a $ore co$-le3 calculation $ay #e
neee"
2or e3a$-le, in the -rouction o+ a range o+ i++erent steel -roucts, the
volu$e o+ steel involve in each i++erent -rouct !oul nee to #e
consiere"
This calculation coul #e -er+or$e #y su$$ing the nu$#er o+ ite$s o+
each -rouct $ae, $ulti-lie #y the !eight o+ each ite$"
This $etho coul use to calculate the total !eight o+ the steel in the
co$-lete -roucts"
066
2or e3a$-le, the +ollo!ing three -roucts $ay #e -rouce uring a
-rouction -erio
Product .eight #um"er
A 12 123
B 8 **
/ 1* 032
I+ the total !eight o+ steel use uring the -erio !as 1*00, then the
e++iciency o+ steel usage coul #e calculate using the +ollo!ing a--roach
1*00
032 1* ** 8 123 12 + +
efficiency usage materials
.1 61
In -ractice, a $anu+acturing o-eration -roucing s$all steel ite$s $ay carry
thousans o+ i++erent -roucts, an co$-uter so+t!are such as inventory
$anage$ent so+t!are or -rouction $anage$ent so+t!are $ay #e use to
generate statistics +ro$ the co$-lete list o+ -rouction runs uring a -erio"
/usto$<!ritten so+t!are -rogra$s an general so+t!are -ackages, such as
s-reasheet -rogra$s, $ay also #e use to -er+or$ this ty-e o+ analysis"
4.8.4.2. 3lant anal$sis
5lant analysis $ay involve revie!ing the ty-e an e++iciency o+ the
e&ui-$ent that is use in -rouction"
A nu$#er o+ a--roaches coul #e use to revie! these issues"
This coul inclue so$e o+ the +ollo!ing -oints"
*00
4.8.4.2.1. 'utomation level
An auto$ation level coul #e calculate to ienti+y the a$ount o+ $echanical
-rouction involve in a -rouction -rocess, co$-are to the a$ount o+
$anual -rocessing involve"
Although e&ui-$ent $ay have a high ca-ital cost an an on<going
e-reciation e3-ense, higher levels o+ auto$ation generally lea to lo!er
overall costs"
The auto$ation level coul #e calculate using the +ollo!ing a--roach"
100
+

ts cos labour on depreciati

on depreciati
level automation
In this calculation, e-reciation !oul relate to -rouction e&ui-$ent an
+acilities only, an !oul not inclue e-reciation o+ other assets such as
#uilings an storage +acilities"
In the case o+ lease e&ui-$ent, the lease -ay$ent coul #e s-lit into an
interest co$-onent an a e-reciation co$-onent, !ith the interest
co$-onent #ase on e#t interest rates an the value o+ the e&ui-$ent"
,a#our costs !oul only inclue costs relating to -rouction activities, rather
than non<-rouction sta++ costs"
An auto$ation level o+ @ero !oul inicate that a -rocess !as co$-letely
$anual, !ith no $achinery #eing use, !hile a level o+ 100L !oul inicate
that the -rocess !as entirely auto$ate, !ith no $anual in-ut to the -rocess"
5o!er generation stations an che$ical -rouction -lants ty-ically have a
high level o+ auto$ation, !hile -rouction o+ han cra+ts $ay #e entirely
$anual"
2or e3a$-le, in a situation !here the e-reciation e3-ense !as G10 an
la#our costs !ere G0, the auto$ation level coul #e calculate using the
+ollo!ing a--roach"
0 10
10
+
level automation
*01
82
A graual ecline in the auto$ation level $ay inicate that e&ui-$ent !as
#eco$ing less e++icient, an that $ore $anual in-ut !as #eing re&uire in the
-rouction -rocess"
4.8.4.2.2. E9uipment age
The average age o+ e&ui-$ent $ay #e calculate to ensure that the +acilities
have not #eco$e out<ate"
This +igure coul #e calculate using the +ollo!ing a--roach"
items of number
item each of age the of sum
age e!uipment average
2or e3a$-le, i+ three $achines !ere installe, !ith ages o+ 6, 18 an 2 years,
then the average age coul #e calculate using the +ollo!ing e3a$-le
3
2 18 6 + +
age e!uipment average
years .3 6
In an o-eration that involve a large nu$#er o+ ite$s o+ e&ui-$ent, this
+igure shoul #e reasona#ly sta#le i+ e&ui-$ent !as regularly re-lace"
This calculation involves a irect average o+ the ages o+ each ite$, an oes
not involve a !eighting ue to the si@e o+ the ite$ o+ e&ui-$ent"
=o!ever, in the case o+ s$aller $achines, these ite$s $ay have the sa$e
i$-act on -rouction ti$e as larger $achines, an in +act a s$all $achine
$ay #e $ore likely to cause a #ottleneck in -rouction than a larger $achine"
*02
4.8.4.2.3. =on*(epreiating e9uipment
%&ui-$ent is generally e-reciate over a ti$e -erio that is e&ual to its
esti$ate !orking li+e"
This involves the #ook value o+ the asset #eing reuce each -erio, !ith a
e-reciation e3-ense #eing inclue in the -ro+it an loss state$ent to re+lect
the reuction in value o+ the e&ui-$ent"
It coul generally #e e3-ecte that the -er+or$ance o+ a $achine $ay #e
reasona#le sta#le uring this -erio"
A+ter the en o+ the e-reciation -erio, the value recore +or the asset
eclines to @ero, an the e-reciation e3-ense ens"
=o!ever, the esti$ate li+e is o+ten a conservative +igure, an it is co$$on
+or e&ui-$ent to #e continue in use +or long a+ter the e-reciation -erio
has +inishe"
This $ay cause no -ro#le$ !hen the e&ui-$ent is -ro-erly $aintaine"
=o!ever, eventually the e&ui-$ent -er+or$ance !ill eteriorate, an also
the level o+ technology $ay +all #ehin the level o+ technology that is
availa#le in ne! $achines"
4on<e-reciation e&ui-$ent re+ers to e&ui-$ent that is use in -rouction,
#ut has -asse the initial e-reciation -erio o+ the esti$ate !orking li+e"
A large -ro-ortion o+ non<e-recating e&ui-$ent $ay suggest that the
overall -rouction -rocess has #eco$e ine++icient, an that a $a9or ca-ital
e3-eniture -rogra$ $ay #e neee"
In cases !here a large nu$#er o+ ite$s o+ e&ui-$ent are use, the +ollo!ing
+or$ula coul #e use"
100

machines of number total
machines ng depreciati non of number
e!uipment ng depreciati non
2or e3a$-le, in an o-eration that involve 8 non<e-reciating $achines an
3* $achines that !ere still !ithin their e-reciation -erio, the +ollo!ing
calculation !oul a--ly
*03
8 3*
8
+
e!uipment ng depreciati non
18
In cases !here only a +e! ite$s o+ e&ui-$ent are use, a $ore relevant
calculation $ay involve the -ro-ortion o+ the -rouction -rocess that !as
-er+or$e #y non<e-reciating e&ui-$ent"
Ane a--roach to this calculation coul use the +ollo!ing +or$ula"
100

ts cos ia0le 4ar total
e!uipment ng depreciati non 0" used ts cos ia0le 4ar
e!uipment ng depreciati non
2or e3a$-le, i+ the cost o+ $aterials, electricity, an la#our e3-enses
involve !ith non<e-reciating $achines !as G1*, an total varia#le cost
!ere G82, then the -ro-ortion o+ the -rouction -rocess than involve non<
e-reciating e&ui-$ent coul #e calculate using the +ollo!ing a--roach
82
1*
e!uipment ng depreciati non
21
4.8.4.2.4. Oupan$ 4ntensit$
4.8.4.2.4.1. +apital intensit$
An occu-ancy ca-ital intensity +igure $ay relate to the si@e an ca-acity o+
the -rouction -rocesses that !ere installe !ithin a -articular #uiling or
area"
In so$e cases, a large lan area or #uiling $ay #e occu-ie #y a #usiness,
!ith the #usiness activity that is conucte #eing s$all in co$-arison to the
lan area"
*00
In these situations, the overall returns +ro$ the #usiness $ay #e lo!er than
an alternative #usiness that occu-ie s$aller +acilities, or that use the +ull
-otential o+ the availa#le area"
The ca-ital intensity o+ #uiling occu-ancy coul #e calculate using the
+ollo!ing a--roach"
ts cos occupancy building
assets facilities & e!uipment
ensity int capital ocupancy
()uipment values & occupanc* costs
In this calculation, the assets +igure !oul inclue e&ui-$ent an
$anu+acturing +acilities, an !oul not inclue general #uilings #eing
occu-ie, storage !arehouses an other assets"
In the case o+ lease e&ui-$ent, the value o+ the assets shoul #e inclue
!ithin the asset value +or the -ur-oses o+ this calculation"
The #uiling occu-ancy costs +igure $ay inclue the costs o+ #uiling leases,
electricity +or heating an lighting, cleaning, an #uiling $aintenance"
In cases !here the #uiling !as o!ne, an e&uivalent rent level shoul #e
use to ena#le the calculation to #e -er+or$e"
In the case o+ -rouction +acilities covering a large lan area, the e&uivalent
occu-ancy cost coul #e esti$ate +ro$ the lan value"
A $ulti-le $ay #e a--lie to the lan value to esti$ate an e&uivalent
e++ective occu-ancy cost"
As an e3a$-le, a $ulti-le o+ 1L $ay #e use as a rule o+ thu$#"
In the case o+ a -rouction +acility occu-ying lan !ith a value o+ G1*0, this
!oul corres-on to an e++ective occu-ancy cost o+ G12 -er year"
This a--roach $ay allo! the ca-ital intensity o+ a !ie range o+ i++erent
+acilities an #usiness activities to #e co$-are"
*0*
A lo! or eclining value +or this +igure $ay inicate that the #usiness !as
occu-ying a large #uiling area, #ut i not have signi+icant -rouction
+acilities installe !ithin the #uiling or lan area"
4.8.4.2.4.2. 7tilisation intensit$
Although a #usiness $ay have -rouction +acilities installe !ithin a
#uiling or lan area, these +acilities $ay not #e +ully utilise"
The level o+ actual -rouction an inco$e that is generate +ro$ a +acility
$ay #e calculate +ro$ the +ollo!ing +or$ula
ts cos occupancy building
profit net
n utilisatio occupancy
=igh values o+ this +igure $ay suggest that signi+icant #usiness activity !as
occurring !ithin a +acility"
In contrast, lo! or eclining values $ay suggest that +acilities !ere not #eing
+ully utilise, or that occu-ancy costs !ere unnecessarily high in relation to
the #usiness activity"
4.8.4.2.5. +omparisons
In the case o+ +igures that are a++ecte #y the age an e++iciency o+
e&ui-$ent, a tren co$-arison over several years !oul nor$ally #e neee
to eter$ine a clear change"
2igures +ro$ -revious years coul #e use as a #ase +or co$-arison against
current +igures"
So$e +igures can #e irectly revie!e, such as the -ercentage auto$ation
level"
In $any cases, ho!ever, a +igure $ay have little irect relevance, unless it is
co$-are to other +igures"
*0)
This $ay involve +igures +ro$ -revious years, +igures #ase on in+or$ation
-u#lishe #y $a9or co$-etitors, an averages +or an inustry"
7ecisions involving the -urchase o+ ne! e&ui-$ent, an the construction o+
ne! +acilities coul also #e revie!e on the #asis o+ the #e+ore<an<a+ter
a++ect that the change $ay have on so$e o+ the -revious +igures"
*08
4.8.4.3. -argins & finanial anal$sis
4.8.4.3.1. /inanial struture of pro(ution
Manu+acturing is -ri$arily an asset<#ase activity"
This is in contrast to service #usinesses, !hich $ay #e cash +lo! #ase
o-erations, an evelo-$ent activities, !hich are -ro9ect<#ase"
Manu+acturing o-erations can #e assesse on an asset #asis, or an inco$e an
e3-ense #asis"
The asset vie! $ay inclue the +ollo!ing etails
Asset value 200
4et 5ro+it 1)
Return on Assets 1 L
This -resents a static -icture o+ the #usiness o-eration"
Alternatively, an inco$e<an<e3-ense vie! can #e taken"
This $ay inclue the +ollo!ing $a9or ite$s
Inco$e
Sales )1
%3-enses
/ash e3-enses 2*
7e-reciation 20
Total %3-enses 0*
4et 5ro+it 1)
*01
The inco$e<an<e3-ense vie! -resents a yna$ic vie! o+ the #usiness
o-erations over a -erio o+ ti$e"
The asset value is relevant in the conte3t o+ the +inancial value o+ the assets"
In theory, the assets coul #e sol +or the $arket value an the +uns coul
#e investe else!here"
=o!ever, the #usiness value $ay #e higher or lo!er than the asset value"
The #usiness value is so$eti$es calculate as a $ulti-le o+ net -ro+it"
2or e3a$-le, a $ulti-le o+ 10 ti$es earnings $ay #e use to value a
-articular #usiness"
In this e3a$-le, the #usiness value !oul #e calculate as the net -ro+it value
$ulti-lie #y 10"
This !oul corres-on to a valuation rate o+ 8"1L, !hich !oul #e e&ual to
one ivie #y the valuation $ulti-le"
In this case, the +ollo!ing +igures !oul a--ly"
Asset iew ,ncome-and-e%pense view
Assets 200 Inco$e
Sales )1
%arnings #e+ore interest 1)
%3-enses
Return on Assets 1 L /ash e3-enses 2*
7e-reciation 20
Total %3-enses 0*
%arnings #e+ore interest 1)
'aluation Multi-le 10
'aluation Rate 8"1 L
Business 'alue 220
*06
4.8.4.3.2. /un(ing struture
The +uning o+ the assets through a co$#ination o+ e#t an e&uity is a
se-arate issue +ro$ the o-erational structure o+ the #usiness"
The return<on<assets $ay #e a -articularly relevant +igure +or a
$anu+acturing o-eration"
This +igure recors the net return +ro$ o-erating the ca-ital assets, ignoring
any +uning issues"
In the case o+ lease assets, the value o+ the e&ui-$ent shoul generally #e
inclue !ithin the total assets +igure +or the -ur-ose o+ calculating a return<
on<assets +igure, to ena#le e++ective analysis an co$-arisons to #e carrie
out"
In cases !here e#t !as use, the return on e&uity !oul #e higher than the
return on assets !hen the return on assets e3ceee the interest rate on the
e#t, an other!ise it !oul #e lo!er"
This a++ect is illustrate in the +ollo!ing +or$ula, relating the return<on<
assets to the -re<ta3 return<on<e&uity"
In this +or$ula, the gearing rate :g; is e&ual to the e#t value ivie #y the
total assets"
( ) rate erest int debt "#A
g
g
"#A "#E

+
1
*10
4.8.4.3.3. 3ro(ution leverage
The inco$e an e3-ense structure o+ a $anu+acturing #usiness can #e #roken
o!n into the +ollo!ing -arts"
,ncome (%penses
Sales 4et 5ro+it
'aria#le cash e3-enses
2i3e cash e3-enses <<<<Q total +i3e
7e-reciation <<<<Q costs
The +i3e costs re$ain the sa$e in each -erio, regarless o+ the level o+
-rouction an sales"
The varia#le cash e3-enses an the net -ro+it vary !ith the level o+ sales"
The ter$ :-rouction leverage; coul #e use to re+er to the e++ect that the
-ercentage change in the net -ro+it is larger than a -ercentage change in
sales, ue to the +act that a -ro-ortion o+ the cost #ase oes not change as the
level o+ sales changes"
The -rouction leverage coul #e calculate using the +ollo!ing +or$ula
( )
( ) ts cos fixed t cos iable var unit price sale unit units num
t cos iable var unit price sale unit units num
leverage production

2or e3a$-le, in the case o+ the +ollo!ing +igures, the -rouction leverage
coul #e calculate using the -revious +or$ula"
4u$#er o+ units 1000
Hnit sale -rice 1"20
Hnit varia#le cost 0"*0
2i3e /osts *00
*11
( )
( ) *00 * 0 2 1 1000
* 0 2 1 1000

. .
. .
leverage production
* 3.
A rise or +all in sales at this level o+ -rouction !oul lea to 3"* ti$es the
-ercentage change in net -ro+it"
The -rouction leverage is not a +i3e value, an the leverage rate changes
!ith the level o+ -rouction"
The +ollo!ing gra-h illustrates the cost -er unit, net -ro+it, an -rouction
leverage than $ay occur at various levels o+ -rouction"
Costs/ 3rofit & 3ro(uction 'everage
*3"
*2"
*1"
"
1"
2"
3"
" 5 1" 15 2" 25 3" 35 4"
1olume
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'
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a
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+ost 3er 7nit
=et 3rofit
3ro(ution 8everage
+igure 5
*12
4.8.4.3.4. -argin & return anal$sis
4.8.4.3.4.1. -argins an( ,eturns
The +or$at #elo! illustrates one -ossi#le layout +or a su$$ary analysis o+
the $argins +ro$ a $anu+acturing o-eration"
These +igures coul #e calculate +or iniviual -roucts, an also +or the
co$-lete -rouction volu$e using total a$ounts an using !eighte
averages +or -er<unit +igures"
Margins an returns can #e analyse to eter$ine rising or +alling trens over
ti$e, co$-are !ith inustry averages, an co$-are against #ase levels +or
invest$ent returns an other -ara$eters"
These +igures coul also #e use to revie! -ossi#le -ro9ects an alternative
+acilities or -rocesses, an to revie! the a++ect that u-ating e&ui-$ent an
other changes $ay have on the $anu+acturing o-eration"
*13
Production Design
Capacit*
Hnit sale -rice 1"20
Hnit varia#le /ost 0"**
4u$#er o+ units 123 1*0
Sale value 108")0 110
2i3e /osts 80 80
2i3e /ost -er unit 0"*8 0"08
Total /ost -er Hnit 1"12 1"02
'aria#le /osts )8")* 12"*
Total /osts 138")* 1*2"*
4et sales value 6"6* 28"*
5rouction $argin *0 L *0 L
Sales Margin )"8 L 1*"3 L
/a-acity Htilisation 12 L
Asset 'alue 160 160
Return on Assets *"2 L 10"* L
*10
4otesE
sales value P unit sale -rice 3 nu$#er o+ units
varia#le costs P unit varia#le cost 3 nu$#er o+ units
total costs P +i3e costs M varia#le costs
-rouction $argin P (unit sale -rice I unit varia#le cost) J unit sale -rice
sales $argin P (sales value < total costs) J sales value
ca-acity utilisation P nu$#er o+ units J esign ca-acity
Sales value re-resents the value o+ the ite$s -rouce, rather than the inco$e
receive +ro$ actual sales uring the -erio"
Inco$e +ro$ sales $ay #e higher or lo!er than -rouction, e-ening on !hether
stocks o+ co$-lete goos !here increase or e-lete"
The +igures +or esign varia#le costs are #ase on current actual varia#le costs +ro$
-rouction, rather than e3-ecte costs at a -revious ti$e"
7esign +i3e costs are #ase on the current +i3e cost level, allocate across the
esign ca-acity"
*1*
4.8.4.3.4.2. 3ro(ution margin
The :-rouction $argin; in this case relates to the i++erence #et!een the
sale -rices an the varia#le in-ut costs"
The -rouction $argin in this e3a$-le is calculate as the -ercentage o+ the
sale -rice o+ an ite$ that is retaine, a+ter -aying the irect costs o+
-roucing the ite$"
This involves the e++iciency o+ the -rouction -rocess an the sale -rices"
The -rouction $argin involves the a$ount o+ ra! $aterials use in
-rouction, an the i++erence #et!een the -rices o+ sol ite$s an the cost
o+ su--lies"
The -rouction $argin oes not involve the ca-ital cost o+ the e&ui-$ent an
+acilities, an it is not a++ecte #y the level o+ -rouction"
The -rouction $argin can #e calculate using the +ollo!ing +or$ula
( )
unit per price sale
unit per t cos iable var unit per price sale
in arg m production

4.8.4.3.4.3. #ales margin

The :sales $argin; is e+ine in this e3a$-le as the net $argin receive #y
the #usiness"
The sales $argin inclues the allocation o+ +i3e costs, such as the
e-reciation o+ the ca-ital +acilities, across the -rouction level that occurre
uring the -erio"
The sales $argin is a++ecte #y the -rouction $argin, the volu$e o+
-rouction, an the ca-ital cost o+ the +acilities"
( )
unit per price sale units num
ts cos fixed unit per t cos iable var unit per price sale units num
in arg m sales

*1)
4.8.4.3.4.4. ,eturn on 'ssets
The return on assets is the net -ro+it +ro$ o-erations, #e+ore +uning costs
such as interest, as a -ercentage o+ the asset #ase"
This can #e use to asses the e++iciency an -rouction levels o+ the
$anu+acturing o-eration, an also to co$-are the returns against alternative
uses +or the asset ca-ital"
The return on assets +igure can #e calculate using the +ollo!ing +or$ula
assets
tax & erest int before earnings
assets on return
An alternative +or$ula, liste #elo!, highlights so$e o+ the varia#les an
issues that $ay a++ect the return on assets +igure"
ratio t cos fixed n utilisatio capacity in arg m production capacity sales "#A
In this +or$ula, each o+ the ter$s is e+ine in the +ollo!ing !ay"
assets
volume design
price sales capacity sales
assets
ts cos fixed
ratio t cos fixed
capacity volume design
produced units of number
n utilisatio capacity
Three alternative +or$ulas +or calculating the net -ro+it are liste #elo!"
%ach +or$ula highlights a i++erent set o+ issues a++ecting the net -ro+it result
*18
( ) ts cos fixed unit per t cos iable var unit per price sale sales num profit net
ts cos fixed value sales in arg m production profit net
( ) ts cos fixed capacit" design n utilisatio capacit" unit per t cos ia0le 4ar unit per price sale profit net
4.8.4.3.4.5. +alulations base( on multiple pro(uts
In $ost cases, a range o+ -roucts !oul #e -rouce"
The -revious $argin analysis coul #e -er+or$e +or each iniviual
-rouct, an also +or the +ull -rouction volu$e #y using !eighte averages"
Deighte average +igures coul #e use +or +igures that relate to a single
unit"
In this conte3t, a :!eight; oes not re+er to a -hysical !eight"
The !eight o+ an ite$ in this conte3t re+ers to the i$-ortance o+ the ite$
!ithin the average, an the si@e o+ the i$-act that an iniviual ite$ !oul
have on the total +igure"
2or e3a$-le, i+ a #usiness ha one e#t !ith a value o+ G100 an another
e#t !ith a value o+ G1*, the interest rate on the +irst e#t !oul have a
greater i$-act on the total interest cost than the interest rate on the secon
e#t"
The average sale -rice -er unit coul #e calculate using the +ollo!ing
+or$ula"
units of number total
product each for ' units of number price sale ' the of sum
price sale

2or e3a$-le, the +ollo!ing ite$s $ay #e -rouce uring a -erio

*11
*16
Product sale price 6uantit*
*20
*21
A 1"23 30*
*22
B 0")0 0*
*23
/ 3"30 *)*
*20
The !eighte average sale -rice coul then #e calculate using the +ollo!ing
e3a$-le"
*)* 0* 30*
*)* 30 3 0* )0 0 30* 23 1
+ +
+ +

. . .
price sale
0* 2.
The use o+ !eighte averages !oul allo! the cost<-er<unit an $argin
calculations to #e -er+or$e across the +ull volu$e o+ -rouction uring a
-erio"
4.8.4.3.4.!. /i)e( & variable osts
Manu+acturing costs can #e are #roken into t!o categoriesB +i3e costs an
varia#le costs"
2i3e costs $ay inclue e-recation, #uiling rents, an general e3-enses
such as a$inistration"
These are costs that are +i3e ollar a$ounts an o not vary as the volu$e
o+ -rouction changes"
'aria#le costs $ay inclue ra! $aterials, +uel an electricity, an in so$e
cases la#our costs +or overti$e, te$-orary an contract !orkers"
The total varia#le cost changes !ith the volu$e o+ -rouction"
'aria#le costs are a +i3e a$ount -er ite$, !hile the +i3e costs are a +i3e
a$ount +or each -erio o+ ti$e"
The average cost<-er<unit is #ase on the total o+ the +i3e an the varia#le
costs that !ere incurre uring a -erio o+ ti$e"
-he proportion of fi%ed to varia"le costs
*2*
In general ter$s, high ca-acity e&ui-$ent an auto$ate +acilities $ay have
high +i3e costs an lo! varia#le costs, !hile lo! ca-acity +acilities an
$anual -rocesses $ay have high varia#le costs an lo! +i3e costs"
The -ro-ortion o+ +i3e to varia#le costs eter$ines the leverage o+ net -ro+it
to changes in -rouction levels"
A #usiness !ith a high -ro-ortion o+ +i3e costs $ay have a high leverage to
rising or +alling sales, !hile a #usiness !ith a high -ro-ortion o+ varia#le
costs $ay e3-erience a graual change in -ro+it as sales rise or +all"
2or e3a$-le, the ta#le #elo! sho!s the +igures +or t!o i++erent
co$#inations o+ +i3e an varia#le costs
Operation ' Operation B
#ale 3rie 3er 7nit 1" 1"
/i)e( +ost 1"" 1"""
:ariable +ost 3er 7nit 5 3
3ro(ution =et 3rofit =et 3rofit
:olume
" *1"" *1?"""
1 *95 *993
1" *5" *93"
1"" 4"" *3""
1?""" 4?9"" !?"""
1"?""" 49?9"" !9?"""
1""?""" 499?9"" !99?"""
Brea6*even 3ro(ution
:olume 2" 143
The #reak<even sales volu$e can #e calculate using the +ollo!ing +or$ula
unit per t cos iable var unit per price sale
ts cos fixed
volume sales even brea$

*2)
In this e3a$-le, o-eration A has lo!er +i3e costs than o-eration B, #ut
higher varia#le costs"
This ta#le illustrates t!o key -oints"
In this e3a$-le, the #reak<even -oint is higher +or the o-eration !ith the
higher +i3e costs than +or the o-eration !ith the high varia#le costs"
This #reak<even -oint +or each o-eration !oul e-en on the level o+ the
+i3e an varia#le costs"
=o!ever, in general the #reak<even -rouction level !oul #e higher in a
+acility !ith a high -ro-ortion o+ +i3e costs, in co$-arison to a +acility !ith
a high -ro-ortion o+ varia#le costs"

In all cases the o-eration !ith the high +i3e an lo! varia#le costs !oul
have a higher -rouction leverage that the alternative o-eration"
Dhen sales !ere lo!, the loss !oul #e greater in an o-eration !ith high
+i3e costs, !hile !hen sales are high, the -ro+it !oul #e greater in the
high<+i3e<cost o-eration than in the high<varia#le<cost o-eration"
In other ter$s, i+ a large invest$ent is $ae in high ca-acity e&ui-$ent, then
a high leverage o+ -ro+it levels to sales volu$es $ay #e create"
Costs per unit
The +i3e cost -er unit can #e calculates using the +ollo!ing +or$ula
units num
ts cos fixed
unit per t cos fixed
This +or$ula coul also #e e3-resse using the ca-acity utilisation rate, as in
the +ollo!ing +or$ula"
n utilisatio capacity volume design
t cos fixed
unit per t cos fixed

*28
The total cost -er unit can #e calculate using the +ollo!ing +or$ula
units num
ts cos fixed
unit per t cos iable var unit per t cos +
2or e3a$-le, i+ the varia#le cost !as 1"0* -er unit, an the +i3e cost !ere
12,000, an the ca-acity utilisation !as 8*L, then the total cost -er unit
coul #e calculate using the +ollo!ing e3a$-le
1*000
12000
0* 1 + . unit per t cos
2* 2.
This +or$ula coul also #e e3-resse in ter$s o+ ca-acity utilisation, as
escri#e in the +ollo!ing +or$ula
n utilisatio capacity volume design
t cos fixed
unit per t cos iable var unit per t cos

+
*21
The +ollo!ing ta#le -resents the varia#le cost, +i3e cost, an total cost +or a
single unit at various levels o+ -rouction
3ro(ution :ariable /i)e( Total
8evel +ost +ost +ost
1"< 1.45 !."" 7.45
2"< 1.45 3."" 4.45
3"< 1.45 2."" 3.45
4"< 1.45 1.5" 2.95
5"< 1.45 1.2" 2.!5
!"< 1.45 1."" 2.45
7"< 1.45 ".8! 2.31
8"< 1.45 ".75 2.2"
9"< 1.45 ".!7 2.12
1""< 1.45 ".!" 2."5
5i8e(/ 1ariable & Total Costs per unit
"
2
4
!
8
"< 2"< 4"< !"< 8"< 1""<
Capacity 7tilisation
C
o
s
t
:ariable ost per unit
/i)e( ost per unit
Total ost per unit
*26
2igure 0
As illustrate in the gra-h a#ove, the cost -er unit eclines !ith increasing
ca-acity utilisation as a curve, not a straight line"
/osts are reasona#ly sta#le at high levels o+ -rouction, ho!ever the cost<
-er<unit rises ra-ily at lo! -rouction levels"
The actual e3tent o+ the curve !oul e-en on the -ro-ortion o+ +i3e an
varia#le costs"
A +acility !ith a high -ro-ortion o+ varia#le costs !oul have a shallo!
curve, !ith costs varying graually at i++erent -rouction levels"
In the case o+ high<ca-acity -lants !ith a large -ro-ortion o+ +i3e costs, a
stee- curve $ay a--ly, !ith large i++erences in cost<-er<unit at i++erent
-rouction levels"
*30
4.8.5. +reating t.e manufaturing proess
4.8.5.1. 3lant (esign
4.8.5.1.1. 3ro%et (evelopments
The esign o+ a ne! $anu+acturing +acility involves en engineering esign
-rocess"
2ro$ the -ers-ective o+ the #usiness analysis, so$e o+ the +ollo!ing
attri#utes o+ a $anu+acturing +acility $ay #e relevant"
The ca-ital cost o+ the -ro9ect"
The e3-ecte li+eti$e o+ the +acility
The -rouction ca-acity, such as the nu$#er o+ units -er $onth"
The ty-e an volu$e o+ ra! $aterials re&uire"
The ty-e an a$ount o+ other su--lies involve, such as electricity
an gas su--lies"
The cost -er unit o+ -rouction, assu$ing an average $eiu$<ter$
-rice +or ra! $aterials"
The cost -er unit at varying -rouction levels, such as o-erations
occurring at hal+ esign ca-acity"
In so$e cases, a $anu+acturing +acility is #uilt as a single -ro9ect, $aintaine
an o-erate, an eventually close"
These situations occur !ith -o!er generation +acilities, che$ical -rouction
-lants, an so on"
The ca-acity o+ various stages in a -ro9ect +acility is generally #alance, an
the -lant $ay #e esigne to a s-eci+ic rate -rouction volu$e ca-acity"
*31
In these situations, general $aintenance an re-airs $ay #e involve, along
!ith the occasional re-lace$ent o+ iniviual ite$s o+ e&ui-$ent"
=o!ever, the o-erating -er+or$ance o+ i++erent sections o+ the -lant $ay
eteriorate at a si$ilar rate, an !hen the o-erating -er+or$ance o+ the -lant
ha eteriorate signi+icantly, the entire -lant $ay #e close an a ne!
+acility $ay #e evelo-e"
4.8.5.1.2. Evolve( plants
In the case o+ general $anu+acturing, an iniviual site $ay #e use over a
long -erio o+ ti$e"
In these cases, a !ie range o+ e&ui-$ent o+ varying ca-acities an ages $ay
#e installe"
In situations such as this, the esign o+ the -lant an the +acilities $ay nee
to #e revie!e on a regular #asis"
In cases !here a +acility ha change $any ti$es since it !as +irst #uilt, a
nu$#er o+ issues $ay arise"
(stimating capacit*
Inustrial $achinery is generally rate to a -articular ca-acity"
2or e3a$-le, a -rinting $achine $ay #e rate at 10,000 -ages -er hour, !ith
an e3-ecte li+eti$e o+ 1 years, an a uty cycle o+ 200 hours o-eration -er
$onth"
In the case o+ a -ro9ect evelo-$ent, an entire +acility $ay #e rate at a
-articular esign ca-acity"
=o!ever, in the case o+ general $anu+acturing, esti$ating the ca-acity o+ a
co$-lete -rouction -rocess $ay #e a co$-le3 e3ercise"
A large section o+ the analysis o+ -rouction an the +inancial structure o+ a
$anu+acturing o-eration involves calculations #ase on the $a3i$u$
ca-acity o+ the -rocess"
*32
This +igure can #e esti$ate +ro$ the rating o+ each iniviual $achine in
the -rocess, together !ith ti$e allocations +or e&ui-$ent setu- +or -rouction
runs, scheule $aintenance, an so on"
This !oul allo! the $a3i$u$ through-ut to #e calculate"
This +igure $ay then +or$ the re+erence -oint against !hich calculations
such as +i3e costs, ca-acity utilisation an so on coul #e -er+or$e"
Aligning the capacit* of process stages
%sti$ating the -rocess ca-acity $ay highlight situations !here -arts o+ the
-rocess $ay have i++ering ca-acities"
I+ large i++erences occur, then i$-rove$ents in e++iciency $ay #e -ossi#le
#y increasing the ca-acity o+ slo! stages, to allo! the high<ca-acity sections
o+ the -rocess to #e +ully utilise"
1utdated e)uipment
In an evolve +acility, iniviual $achines $ay vary !iely in age, an in
so$e cases an iniviual $achine $ay #e outate an $ay elay the entire
-rouction -rocess"
This $ay also involve aitional e3-enses +ro$ +re&uent $aintenance, a high
level o+ $anual in-ut, an re<!orking o+ +aulty -roucts"
In these cases a signi+icant i$-rove$ent $ay result +ro$ re-lacing a
co$-onent o+ the -rocess !ith ne! e&ui-$ent"
4.8.5.1.3. #mall enterprises
In the case o+ s$all $anu+acturing o-erations, -lant esign $ay involve
selecting the ite$s o+ e&ui-$ent to #e use"
A large $achine that -er+or$e several +unctions $ay result in e++icient
-rouction"
=o!ever, high ca-acity e&ui-$ent $ay also have a high ca-ital cost"
*33
Avantages !ith using several s$aller $achines $ay inclue that +act that
greater +le3i#ility $ay #e achieve, an also that the iniviual $achines
coul #e #ought or sol in stages"
4.8.5.2. 3roess (esign
5rocess esign involves selecting the e&ui-$ent to #e use, an esigning
the o-erating -rocess"
In $any cases a !ie range o+ e&ui-$ent $ay #e availa#le +or $anu+acturing
o-erations, !ith varying ca-acities, an -er+or$ing various i++erent
+unctions"
A single $achine that -er+or$e several i++erent +unctions !oul generally
allo! +or $ore e++icient -rouction than several iniviual $achines"
=o!ever, this $ay also #e a less +le3i#le arrange$ent than iniviual
$achines, as in so$e o-erations the +acilities re&uire o+ each stage $ay #e
i++erent to the $achine +acilities, e-ening on the other -rocesses involve
in -rouction"
A large nu$#er o+ ste-s $ay #e involve +ro$ the -oint at !hich ra!
$aterials arrive, to the -oint at !hich the goos are co$-lete an reay +or
shi--ing"
An e3isting -rouction -rocess coul #e revie!e #y checking so$e o+ the
+ollo!ing issues"
The ti$e taken to co$-lete each stage in the -rocess"
The -ro-ortion o+ ti$e s-ent !ith e&ui-$ent o-erating, co$-are to
ti$e re&uire +or e&ui-$ent set<u-, trans-orting su--lies, an so on"
Ienti+ying any stage that -revente -revious stages +ro$
o-erating at +ull ca-acity"
The +ault rate occurring at each stage"
The costs o+ each stage in ter$s o+ ra! $aterials, $anual in-ut,
storage s-ace, +uel etc"
*30
Attention to the co$-lete -rocess, incluing the e&ui-$ent involve in each
stage, an the -rocesses use to co$-lete the -rouction, $ay have a
signi+icant i$-act on ca-acity an costs"
2or e3a$-le, although the ca-acity rating o+ a $achine $ay set the
$a3i$u$ -rocess ca-acity, the actual ca-acity o+ the co$-lete -rocess $ay
#e signi+icantly lo!er than the $achine ca-acity, ue to the other ste-s
involve in a co$-lete -rouction cycle"
2or e3a$-le, a $achine $ay have a ca-acity o+ 2,000 units -er hour"
I+ the $achine o-erate +or t!o hours, !hile $aterials trans-ort, set<u- an
other activities re&uire one hour, then the ca-acity o+ the -rouction -rocess
!oul #e 1,333 units -er hour, not 2,000 units -er hour"
The ca-acity o+ a -rouction -rocess using a single $achine can #e
calculate using the +ollo!ing +or$ula
time do(n average time run average
time run average
capacity machine capacity production
+

In the -revious e3a$-le, the +ollo!ing calculation !oul a--ly
1 2
2
2000
+
capacity production
hour per units )333 1
/hanges in -rocesses $ay allo! $achines to o-erate uninterru-te +or long
-erios o+ ti$es, !ith short o!n<ti$e -erios #et!een -rouction runs"
4.8.5.2.1. /ault rates
2ault rates $ay #e a signi+icant issue in the esign o+ a $anu+acturing
-rocess"
A +ault $ay involve a +aulty -rouct"
*3*
Also, this issue $ay arise in the case o+ -rouction sto--ages, !hich $ay
reuce ca-acity an increase costs"
2aults $ay inclue so$e o+ the +ollo!ing ite$s
5roucts that are $issha-en or incorrectly +or$e"
5roucts that are outsie $anu+acturing tolerances"
5rouction sto--ages"
2aults $ay #e cause #y so$e o+ the +ollo!ing issues"
Dorn<out e&ui-$ent, !hich $ay 9a$, $is<sta$- ite$s or -rouce
+aulty goos in other !ays"
Mistakes in setting u- e&ui-$ent, such as $istakes in installing
$ouls, or setting $achine -ara$eters +or a -rouction run"
5rocesses that are e3cessively la#our<intensive or -oorly esigne"
5oor &uality ra! $aterials"
Machines #eing use incorrectly"
2or e3a$-le, -oor &uality ra! $aterials $ay create a nu$#er o+ -otential
-ro#le$s"
This $ay lea to $achines 9a$$ing, &uality -ro#le$s in che$ical or
$aterial -rouction, an -roucts #eing create !ith i$ensions or
-er+or$ance that $ay #e outsie the -rouct esign tolerances"
Also, $aterials $ay have a certain -ro-ortion o+ +aulty ite$s or #atches
!ithin the $aterial itsel+"
4.8.5.2.1.1. T.e natural fault rate of a proess
*3)
The +ault rate o+ a -rocess is eter$ine !hen -rocess is esign an create,
not #y the !ay the -rocess is o-erate"
A+ course, a -rocess cannot -rouce its esign -otential unless it is o-erate
correctly"
=o!ever, a $achine that -rouces three +aults -er $illion ite$s !ill never
-rouce three +aults -er hunre i+ everything is o-erating -ro-erly, an a
$achine that -rouces three +aults -er hunre !ill never -rouce three
+aults -er $illion"
4o -rocess has a +ault rate o+ @ero"
Fust as hu$an error occurs at rano$ $o$ents, $achines an -rouction
-rocesses also generate a -ercentage o+ +aulty out-uts"
=igh ca-acity $achines an +acilities $ay #e rate at a certain average +ault
rate, such as 20 +aults -er $illion ite$s -rouce"
2aulty ite$s $ay re&uire a consiera#le level o+ $anual in-ut to correct an
re<!ork the ite$, they $ay halt -rouction +or a -erio o+ ti$e, an the
-rocess +or re<!orking +aults $ay +ill a signi+icant section o+ the +acility"
2ault rates $ay #e reuce #y ensuring that e&ui-$ent is re-lace as soon as
its o-erating -er+or$ance #egins to eteriorate signi+icantly"
Also, continuous -rocesses generally have lo!er +ault rates than #atch
-rocesses"
A $achine that -er+or$s several +unctions $ay reuce the +ault rate in so$e
circu$stances, co$-are to using several iniviual $achines"
A large increase in -rouction e++iciency $ay so$eti$es occur through
revie!ing +ault rates at each stage o+ the -rouction -rocess, an re-lacing
e&ui-$ent or aressing -rocess -ro#le$s !here +aults cause a #ottleneck in
-rouction"
4.8.5.2.1.2. -easuring fault rates
A +ault rate $ay not #e a#le to #e e++ectively $anage unless it is $easure
over an e3tene -erio o+ ti$e"
*38
2or e3a$-le, the nu$#er o+ +aults $ay #e recore +or each -rouction run,
as a stanar o-erating statistic"
A -ercentage o+ +aulty goos coul then #e calculate +ro$ the nu$#er o+
+aults an the total nu$#er o+ ite$s -rouce"
In the case o+ -rouction sto--ages, #oth the nu$#er o+ sto--ages an the
total length o+ ti$e $ay #e recore"
Aressing +aults on an a<hoc #asis $ay not result in a -er$anent change to
the #usiness activity or o-erational -rocesses"
Measuring +aults $ay ena#le an assess$ent to #e $ae as to !hether ne!
ite$s o+ e&ui-$ent, or ne! -rocesses, $ay have i$-rove the +ault rate"
Also, this -rocess $ay allo! +ault rates to ecline continuously over ti$e, as
ne! ste-s $ay #e taken at each -oint to esta#lish a +urther reuction in +ault
rates"
7uring the 1680Cs (>>check ecae), an a--roach kno!n as :total &uality
$anage$ent; #eco$e -o-ular !ithin $anu+acturing o-erations"
This a--roach raise +ault rates as a $a9or issue o+ -rouction"
Through a range o+ changes over ti$e, so$e $anu+actures !ere a#le to
reuce +ault rates +ro$ the orer o+ one +ault +or every +e! hunre ite$s, to
a +e! +aults +or every $illion ite$s -rouce"
These changes lea to large increases in -rouction e++iciency an ca-acity,
an signi+icant reuctions in costs<-er<unit in a range o+ cases (>>check
etails)"
4.8.5.2.1.3. ,e(uing fault rates
A nu$#er o+ ste-s $ay #e taken that $ay reuce +ault rates" This $ay
inclue so$e o+ the +ollo!ing -oints"
Sourcing goo &uality ra! $aterials, an testing $aterial #atches
#e+ore use"
Hsing continuous -rouction -rocesses rather than #atch -rocesses"
*31
%nsuring that e&ui-$ent is use correctly"
Re-lacing !orn<out e&ui-$ent"
Re-lacing several -rouction stages #y a single $achine or a link
#et!een $achines"
Auto$ating -rocesses that !ere -reviously -er+or$e $anually"
%nsuring that e&ui-$ent is correctly $aintaine, an regularly
a9uste"
Measuring +ault rates as -er$anent -rouction statistics, an taking
regular ste-s to reuce the structure o+ the +ault rate !ithin the
-rouction -rocess"
Altering -rouction -roceures, such as altering su--ly trans-ort
an loaing $ethos, or -er+or$ing long -rouction runs or relate
runs in relate #atches"
4.8.5.2.2. 3lant effiien$
5lant e++iciency involves the a$ount o+ ra! $aterials that are re&uire to
-rouce a certain volu$e o+ out-ut"
This also involves the +i3e costs o+ the -lant itsel+, an the level o+ e3-enses
such as sta++ costs, that are re&uire in -ro-ortion to the volu$e o+ out-ut
-rouce"
A range o+ conitions $ust #e in -lace +or a -lant to o-erate e++iciently"
This inclues e++icient e&ui-$ent, a !ell esigne -lant structure an
o-erating -rocesses, an e++ective -rouction $anage$ent"
5ro#le$s in any o+ the relevant areas $ay -revent the -lant +ro$ o-erating
e++ectively"
The -lant e++iciency can #e $easure as the total cost -er unit !hen the -lant
is o-erating at +ull ca-acity"
*36
4.8.5.2.3. Bottlene6s
Bottlenecks occur !hen a -articular stage in a -rouction -rocess causes a
signi+icant reuction in the -otential through-ut o+ the -rocess, or causes a
signi+icant increase in costs"
This $ay occur ue to so$e o+ the +ollo!ing causes
A !orn<out ite$ o+ e&ui-$ent"
A $achine that oes not have su++icient ca-acity in relation to the
rest o+ the -rocess"
A stage in -rouction involving a large a$ount o+ $anual in-ut, that
coul -otentially #e auto$ate"
A -oorly esign or $anage -rouction -rocess"
/o<orination an ti$ing -ro#le$s, such as shortages o+ $aterials,
i++erent -arallel stages in the -rocess co$-leting at i++erent rates,
an so on"
Re$oving a #ottleneck $ay increase ca-acity signi+icantly an also reuce
costs"
4.8.5.2.4. +ontinuous vs. bat. proesses
/ontinuous -rocesses involve a -rocess that -rocesses a large nu$#er o+
ite$s continuously over an e3tene -erio o+ ti$e"
In theory, a continuous -rocess coul o-erate at +ull ca-acity ine+initely, as
long as su--lies !ere continuously availa#le an out-ut ite$s !ere re$ove
an store"
In contrast, #atch -rocesses involve a -rouction run that -rouces a s-eci+ic
nu$#er o+ ite$s"
Batch -rocesses are use in s$all scale $anu+acturing, an !hen a large
nu$#er o+ i++erent -roucts are $ae"
%3a$-les o+ #atch -rouction inclue the $anu+acture o+ nuts, #olts an
other s$all ite$s, !here several thousan i++erent -roucts $ay #e stocke"
*00
/ontinuous -rouction is use in high volu$e $anu+acturing, -rocesses such
as che$ical -rouction, an !here a s$all nu$#er o+ -rouct esigns are
involve"
/ontinuous -rocesses generally have signi+icantly lo!er costs an +ault rates
than #atch -rocesses, an $ay -rouce a larger volu$e o+ ite$s over a
-erio o+ ti$e"
Batch -rocesses re&uire setting u- o+ e&ui-$ent in -re-aration +or a
-rouction run, loaing $aterials, an trans+erring +inishe ite$s to the ne3t
stage in the -rocess"
Dhere -ossi#le, i$-le$enting continuous -rocesses !ithin a -rouction
environ$ent $ay lea to signi+icant increases in e++iciency"
2or e3a$-le, !here several $achines are linke together into a single chain,
-rocessing the ite$s $ay involve less o!n<ti$e an +e!er +aults than
o-erating each stage se-arately"
4.8.5.2.5. #plit failities
S-lit +acilities are use !hen a +unction is -er+or$e #y several s$all
$achines rather than a single large $achine"
Although a large ca-acity $achine !oul generally have lo!er costs -er unit
than a s$all $achine !hen o-erating at +ull ca-acity, there $ay #e several
avantages !ith using s-lit +acilities"
Most $achines o-erate at $a3i$u$ e++iciency !hen they are o-erating near
+ull ca-acity"
In a si$ilar !ay to co$-lete -rouction -rocesses, there are +i3e an
varia#le co$-onents !ithin the $aterials an +uel use #y $achines"
Although a large $achine o-erating at +ull ca-acity $ay have lo!er costs -er
unit a s$aller $achine, !hen -rouction is only occurring at hal+ ca-acity, a
s$aller $achine $ay -rovie $ore e++icient -rouction"
Dhen -rouction levels are lo!, the use o+ a single s$all $achine $ay
-rouce a $ore e++icient result than using only -art o+ the ca-acity o+ a large
$achine"
*01
This arrange$ent is co$$on in -o!er generation +acilities, +or e3a$-le"
A gas<+ire -o!er generation +acility $ay contain three gas tur#ines, rather
than a single large tur#ine"
In so$e $anu+acturing -lants, entire sections o+ the -lant are u-licate, an
sections o+ the -lant can #e close !hen -rouction levels are lo!"
Another avantage o+ this arrange$ent relates to #ack<u- +acilities"
Dhen a single $achine or -rocess stage is use, -rouction $ay #e halte in
the event that a +ault evelo-s in the -rocess"
This $ay cause a $a9or -ro#le$ !hen an e3tene -erio o+ ti$e is re&uire
to restore the $achine or +acility to an o-erational conition"
Dhen several ite$s o+ e&ui-$ent are use, -rouction $ay #e a#le to
continue !hen one ite$ is unavaila#le ue to a +ault, or is unavaila#le ue to
$aintenance activities"
4.8.5.2.!. 3arallel & series proesses
The -rouction o+ an iniviual ite$ generally involves a nu$#er o+ se-arate
o-erations"
Series -rocesses involve a set o+ stages that are -er+or$e in se&uence, !ith
an ite$ -assing +ro$ the +irst stage to the secon stage, then the thir stage
an so on"
5arallel -rocesses involve several ine-enent activities occurring at the
sa$e ti$e"
2or e3a$-le, an ite$ o+ e&ui-$ent $ay #e constructe +ro$ three $a9or
sections"
A series -rocess $ay #egin !ith the +irst section #eing constructe"
The -artially co$-lete ite$ $ay then -ass to the secon stage +or
co$-letion o+ the secon section, an +inally to the +inal stage +or co$-letion
o+ the +inishe -rouct"
A -arallel -rocess $ay involve all three sections #eing ine-enently
constructe at the sa$e ti$e"
*02
A +ourth stage !oul then involve asse$#ling the three su#<sections into a
+inishe -rouct"
This can #e illustrate using the +ollo!ing iagra$s
Series -rocess
<<<<< stage 1 <<<<<<< stage 2 <<<<<<< stage 3 <<<<<<< co$-letion
5arallel -rocess
<<<<< stage 1 <<<<<M
M
<<<<< stage 2 <<<<<M <<<<<<< stage 0 <<<<<<< co$-letion
M
<<<<< stage 3 <<<<<M
The choice #et!een a series an a -arallel -rocess $ay not signi+icantly alter
the activity that occurs !ithin each iniviual stage, nor $ay it alter the total
costs or the volu$e ca-acity o+ the -rocess"
=o!ever, a -arallel -rocess reuces the ti$e taken to co$-lete a s-eci+ic
ite$"
2or e3a$-le, i+ each stage re&uire 10 ays to co$-lete, then a series -rocess
!oul re&uire 30 ays to co$-lete an iniviual ite$, !hile a -arallel
-rocess !oul re&uire only 10 ays"
This reuction in -rocessing ti$es $ay #e o+ #ene+it in -roucing s-eci+ic
custo$ -roucts #ase on client orers"
This a--roach $ay #e -articularly relevant in #usiness o-erations !here all
the ite$s are #uilt accoring to s-eci+ic client orers"
*03
Builing construction is one e3a$-le o+ this situation"
In these cases, the use o+ a -arallel a--roach $ay lea to consiera#le
savings in interest costs #y signi+icantly reucing the ti$e taken to co$-lete
a -ro9ect"
Dithin $anu+acturing, a -arallel a--roach $ay allo! the #usiness to su--ly
s-eci+ic orers $ore &uickly, an to reuce the elays involve in res-oning
to changing levels o+ sales e$an"
In the case o+ an iniviual ite$, the ti$e involve in -roucing an ite$
through a series -rocess !oul #e the su$ o+ the total ti$es re&uire in each
stage"
Dithin a -arallel -rocess, the ti$e elay !oul #e e&ual to the ti$e re&uire
+or !hichever stage re&uire the longest ti$e -erio to co$-lete"
2or e3a$-le, the +ollo!ing stages $ay #e involve in a -rouction -rocess"
Stage -ime ,nvolved
1 3
2 6
3 *
0 8
Series -rocess ti$e 20
5arallel -rocess ti$e 6
In the case o+ continuous -rouction, all the stages !oul nee to have the
sa$e -rouction rate, regarless o+ !hether a -arallel or a series -rocess !as
involve"
In cases !here the -otential ca-acity o+ each stage !as i++erent, the -rocess
ca-acity !oul #e set #y the stage that ha the lo!est -rouction rate"
This situation !oul a--ly !hether a series or a -arallel -rocess !as use"
*00
4.8.5.2.7. /ault tolerane
5arallel -rocesses $ay also -rovie a level o+ +ault tolerance to the
-rouction -rocess"
Dhen a stage !ithin a series -rocess is halte, this $ay -revent all +urther
stages +ro$ o-erating"
%arlier stages coul continue o-eration, u- to the -oint that !as eter$ine
#y the storage s-ace availa#le $i<!ay through the -rocess +or -artially
co$-lete ite$s"
A si$ilar situation $ay occur in a -arallel -rocess"
A -rouct cannot #e asse$#le an co$-lete until all the iniviual
co$-onents are availa#le"
=o!ever, in the case o+ a -arallel -rocess, other co$-onents o+ the -rocess
coul continue o-eration !hen a single stage !as halte"
This is in contrast to a series -rocess, !here only the earlier stages coul
continue o-eration"
This o-eration !oul #e li$ite #y the a$ount o+ storage s-ace that !as
availa#le to store the out-ut o+ each iniviual stage, until the +inal asse$#ly
-rocess coul #e re<starte"

4.8.5.2.8. 'tten(e( & 7natten(e( proesses
So$e $achines an -rocesses $ay involve an o-erator loaing each
iniviual ite$, an selecting +unctions +or the -rocessing o+ each ite$ that is
-rocesse"
Ather $achines an -rocesses can o-erate continuously +or long -erios o+
ti$e !ithout hu$an involve$ent"
This $ay occur !hen large ca-acity in-ut storage is use +or ra! $aterials,
!hen conveyer syste$s are use to trans-ort ite$s +ro$ one $achine or
-rocess stage to the ne3t, an !hen auto$atic selection o+ -rocess o-tions is
-er+or$e #y $achines or -rocess control e&ui-$ent"
Hnattene -rocesses $ay have a range o+ avantages over attene
-rocesses"
*0*
5rouction volu$es an &uality control $ay #e higher !ith unattene
-rocesses than !ith $anually o-erate -rocesses"
A-erating costs $ay #e lo!er !ith unattene syste$s than !ith attene
syste$s, as an e$-loyee $ay not nee to #e -er$anently statione at each
$achine or -rocess stage"
Also, isru-tions to -rouction +lo! ue to issues such as #reaks an shi+t
changes $ay #e reuce"
Dhere -ossi#le, e&ui-$ent an -rocesses that su--ort unattene o-eration
shoul generally #e use, in -re+erence to -rocesses that re&uire continuous
$anual in-ut"
This a--roach $ay lea to large increases in -rouction ca-acity, an
reuce costs an +ault rates"
4.8.5.3. Eonomies of sale
%cono$ies o+ scale are a +una$ental co$-onent o+ $anu+acturing"
An econo$y o+ scale $ay occur !hen the cost +or -roucing a single unit o+
a -rouct is lo!er !hen high volu$es are -rouce than !hen lo! volu$es
are -rouce"
This $ay #e a general e++ect !ithin $anu+acturing, an $ay occur +or t!o
reasons"
The cost<-er<unit o+ -rouction $ay #e lo!er in the case o+ high ca-acity
e&ui-$ent, than in the case o+ lo! ca-acity e&ui-$ent"
2or e3a$-le, a -rinting $achine that has a ca-acity o+ 10,000 -ages -er hour
$ay -rint each -age at a lo!er cost than a $achine that has a ca-acity o+
1,000 -ages -er hour"
This $ay involve lo!er costs o+ electricity, e-reciation, $aintenance an so
on, !hen the costs are allocate to a single -age o+ -rinte out-ut"
This is the nature o+ $echanical e&ui-$ent"
A secon e++ect $ay involve the +i3e costs o+ the #usiness o-eration"
*0)
/osts such as $arketing an a$inistration costs $ay #e a constant +igure,
regarless o+ the level o+ -rouction an sales"
2or e3a$-le, the sa$e costs $ay #e involve in -rocessing an invoice +or
G100, as -rocessing an invoice +or G10"
In the case o+ $arketing e3-anses, as another e3a$-le, a si$ilar cost $ay #e
involve in negotiating a su--ly agree$ent +or *,000 units, as a su--ly
agree$ent +or 1,000 units"
The cost -er unit $ay #e erive +ro$ the varia#le costs, such as the ra!
$aterials, an a -ro<rata allocation o+ the +i3e costs"
2or e3a$-le, a #usiness $ay have the +ollo!ing costs uner t!o i++erent
-rouction volu$es
,o! =igh
'olu$e 'olu$e
'olu$e 10 00
2i3e costs 120 120
'aria#le cost -er unit * *
2i3e cost -er unit 12 3
Total cost -er unit 18 1
In this e3a$-le, the cost +or -roucing each unit ro-s +ro$ G18 to G1 as the
volu$e o+ -rouction is increase, !ithout any change occurring in the
+acilities, $aterials or -rocesses"
%cono$ies o+ scale $ay also a--ly in the case o+ so$e service #usinesses
an other ty-es o+ #usiness activity"
2or e3a$-le, the cost o+ co$-uterise -rocessing an a$inistration syste$s
$ay #e a +i3e value, !hile varia#le costs $ay a--ly to -rocessing volu$es"
In the case o+ $anaging transactions, such as invest$ent $anage$ent,
-ro9ect $anage$ent an so on, $any activities an costs $ay #e constant,
ho!ever the +ee inco$e $ay vary !ith the si@e o+ the transaction"
*08
In the case o+ licensing ite$s such as esigns, co$-uter so+t!are, $usic an
so on, the costs $ay #e largely +i3e, ho!ever the inco$e $ay increase !ith
the level o+ sales"
In any situation in !hich a -ortion o+ the costs $ay #e +i3e, an $ay not
vary !ith the level o+ sales, then econo$ies o+ scale $ay a--ly"
4.8.5.4. +osts :s. :olumes
The co$#ination o+ lo! costs -er unit +or high ca-acity e&ui-$ent, an
allocating +i3e costs across a large nu$#er o+ units, $ay result in costs -er
unit eclining in the case o+ high -rouction volu$es, or high ca-acity
+acilities"
Ane a--roach to $oelling costs $ay involve a cost -er unit that +alls in line
!ith a curve that is #ase on the volu$e raise to the -o!er o+ a -articular
nu$#er"
2igure 2 on -age 010 illustrates the ecline in cost -er unit !ith increasing
volu$e, #ase on a -olyno$ial curve"
This curve has the -ro-erty that the value eclines #y a constant +igure +or
each -ro-ortional change"
2or e3a$-le, the costs $ay ecline #y the sa$e -ercentage each ti$e that the
-rouction ca-acity !as ou#le"
In the case o+ one rule o+ thu$# that $ay #e use, the cost -er unit $ay +all
#y 00L each ti$e that ca-acity is ou#le (>> check )
(>> check rules o+ thu$#Jty-ical ratios)
2or e3a$-le, !hen ca-acity !as increase +ro$ 10 to 20 units, or +ro$ *,000
to 10,000 units, the cost -er unit $ay +all #e 00L in each case"
4.8.5.5. #ale alulations
An esti$ate cost -er unit o+ -rouction at varying -rouction volu$es $ay
#e calculate using a -olyno$ial curve relationshi-
*01
The cost -er unit o+ -rouction $ay #e re-resente using the +ollo!ing
+or$ula
b
volume a unit per t cos
The +unction o+ raising one nu$#er to the -o!er o+ another nu$#er $ay #e
re-resente in the +or$ y
3
"
This +unction $ay #e availa#le in so$e calculators that $ay inclue
scienti+ic or +inancial +unctions, an in co$-uter so+t!are such as
s-reasheet -rogra$s"
In orer to esti$ate costs at i++erent -rouction levels, an esti$ate $ust #e
$ae +or the values o+ :a; an :#; in the -revious +or$ula"
This $ay #e one in several !ays"
Dhere the costs $ay #e esti$ate at t!o i++erent levels o+ -rouction, the
+ollo!ing +or$ulas $ay #e use"
( ) ( ) 1 2
1
2
volume ln volume ln
t cos
t cos
ln
b

,
_

b
volume t cos a

1 1
In these +or$ulas, the varia#les have the +ollo!ing $eanings"
cost1 The total cost -er unit at -rouction level 1
cost2 The total cost -er unit at -rouction level 2
volu$e1 The nu$#er o+ units at -rouction level 1
volu$e2 The nu$#er o+ units at -rouction level 1
*06
In the +or$ula +or :#;, the +unction :ln; is the natural logarith$ o+ the value,
an is availa#le !ithin so$e calculators an so+t!are -rogra$s"
2or e3a$-le, the +ollo!ing +igures $ay #e availa#le
'olu$e /ost -er unit
10 0"82
30 1"1)
A--lying the -revious +or$ulas, the +ollo!ing values $ay #e calculate +or
:a; an :#;
( ) ( ) 10 30
82 0
1) 1
ln ln
.
.
ln
b

,
_

21 1.
21 1
10 82 0
.
. a


60
Alternatively, only a single set o+ values +or current costs an -rouction
levels $ay #e availa#le"
In this case, a value $ay #e esti$ate +or the value o+ :#;"
This $ay #e #ase on a rule<o+<thu$# a--roach, or it $ay #e calculate +ro$
a set o+ costs an volu$es o+ several i++erent #usinesses that $ay o-erate
!ithin an inustry"
2or e3a$-le, one rule o+ thu$# that $ay #e use in $anu+acturing $ay
involve costs +alling #y 00L each ti$e that -rouction ca-acity is ou#le
(>> check)"
**0
In this case, this $ay corres-on to a value o+ <0"80 +or :#;"
Hsing this value o+ :#;, the value o+ :a; +or the +or$ula $ay #e esti$ate
+ro$ the current cost an volu$e +igures using the +ollo!ing a--roach"
80 0.
volume unit per t cos a
2or e3a$-le, a -rouction +acility $ay currently -rouce *,000 units -er
$onth, at a total cost o+ G8,000"
The current cost -er unit $ay #e eter$ine +ro$ the +ollo!ing +or$ula
units of number
ts cos total
unit per t cos
*000
8000

00 1.
The value o+ :a; $ay then #e esti$ate using the +ollo!ing e3a$-le
2) 0
*000 00 1
.
. a


8)0
=aving esti$ate values +or :a; an :#;, the cost -er unit an the total costs
$ay #e esti$ate +or a range o+ larger -rouction +acilities"
2or e3a$-le, although -rouction levels in the -revious e3a$-le !ere
currently *,000 units -er $onth, an e3-ane +acility $ay #e availa#le +or
-urchase that $ay ena#le -rouction volu$es to #e increase to 20,000 units
-er $onth"
In this case, the cost<-er<unit o+ the e3-ane +acility $ay #e esti$ate using
the +ollo!ing e3a$-le"
**1
b
volume a unit per t cos
80 0
20000 8)0
.

* 0.
Also, the total costs $ay #e esti$ate using the +ollo!ing a--roach
volume unit per t cos ts cos total
000 20 * 0 ) .
000 10)
This e3a$-le illustrates, that using the assu$-tion +or the sha-e o+ the curve
an the rate o+ ecline, the cost -er unit $ay +all +ro$ G1"00 to G0"*0 in the
-revious e3a$-le i+ the ne! +acility !as -urchase, ena#ling -rouction to
increase +ro$ *,000 units -er $onth to 20,000 units -er $onth"
4.8.!. -anaging manufaturing
The e++iciency o+ -rouction relates to the a$ount o+ ra! $aterials that are
neee to -rouce an ite$, the volu$e that can #e -rouce +ro$ e&ui-$ent
o+ a certain value, an the relia#ility an &uality o+ out-ut"
%++icient -rouction re&uires e&ui-$ent that is u-<to<ate an suita#le +or the
-rouction -rocess, e++ective -roceures an -rocesses, an e++ective
-rouction $anage$ent"
4.8.!.1. 3roess ontrol .ar(5are
5rocess control e&ui-$ent involves co$-uter e&ui-$ent use to control +lo!
rates, te$-eratures an -ressures, trans-ort o+ ite$s #et!een -rocess stages,
an so on"
**2
5rocess control e&ui-$ent is -articularly use in high ca-acity continuous
-rouction, !here accuracy is critical, an in -rouction that involves a !ie
range o+ varia#les, such as oil re+ining +acilities"
The use o+ -rocess control har!are an so+t!are $ay lea to signi+icant
i$-rove$ents in &uality levels an -rouction ca-acity, an reuce the
a$ount o+ ra! $aterials that are re&uire to -rouce a -articular volu$e o+
out-ut"
5rocess control is heavily use in -rouction +acilities that are evelo-e as
an integrate +acility on a -ro9ect #asis"
=o!ever, -rocess control can also #e i$-le$ente !ithin general
$anu+acturing o-erations"
This $ay inclue o-erations such as auto$atically recoring volu$es to
recor -rouction in+or$ation, auto$atic trans+er o+ ite$s using conveyor
syste$s, an auto$atic selection o+ $achine o-tions +or i++erent ty-es o+
$aterials an -roucts"
4.8.!.2. -anaging pro(ution
The ai$s o+ -rouction $anage$ent $ay inclue so$e o+ the +ollo!ing
-ointsE
Mini$ising the $aterials an resources that are re&uire to
-rouce a certain volu$e o+ -roucts"
%nsuring that the &uality stanars o+ the +inishe -roucts are
high"
Ma3i$ising the -otential -rouction volu$e availa#le +ro$ a
+acility, to ena#le high -rouction levels to #e $aintaine !hen
sales e$an is high"
Maintaining a +le3i#le an varia#le cost structure, so that high
+i3e costs are not incurre uring -erios o+ slo! sales"
Revie!ing -rouct volu$es, -ro+ita#ility, an -lant e++iciency, as
an in-ut into ecisions to change -rouct structures an to re<invest
in u-ate +acilities"
**3
Managing -rouction $ay involve scheuling -rouction runs, organising
$aintenance, an esigning -rouction -rocesses"
In $any cases, the re&uire$ent +or -roucts !ill #e set #y custo$er e$an,
an this !ill then lea to the re&uire$ents +or -rouction"
=o!ever, the custo$er e$an itsel+ is relate to the -rice o+ the -roucts"
%++ective -rouction $anage$ent $ay ena#le a large volu$e o+ goos to #e
-rouce !ithin a -articular -erio o+ ti$e"
This $ay reuce the cost o+ each ite$, !hich coul +ee through into
increase sales"
4.8.!.2.1. #.e(uling
Scheuling -rouction runs is a $a9or co$-onent o+ -rouction $anage$ent
in $any $anu+acturing o-erations"
This inclues -lanning the orer, length an starting ti$e o+ various
-rouction runs, organising e$-loyee shi+ts, an ensuring that -rocesses are
not elaye ue to a shortage o+ $aterials or other -rocesses not #eing
co$-lete"
5rouction runs shoul generally #e scheule so that there is a $ini$u$ o+
e&ui-$ent set<u- re&uire !hen changing +ro$ one -rouct to another"
In so$e o-erations, the scheuling orer o+ tasks $ay a++ect the elay an
changes re&uire #et!een each -rouction run"
In general, one long -rouction run $ay #e $ore e++icient than several
shorter runs"
This $ay reuce the set<u- ti$e re&uire +or the e&ui-$ent, an $ay also
reuce the ti$e involve in the overall -rocess, such as locating the relevant
su--lies an trans-orting $aterials"
=o!ever, this $ay nee to #e #alance against the +act that a long -rouction
run $ay re&uire $ore ra! $aterials an higher inventory levels that using
short -rouction runs, an $ay also re&uire $ore storage s-ace +or the
co$-lete -roucts"
**0
Maintenance o+ e&ui-$ent $ay #e scheule at ti$es !hen it !ill have the
least i$-act on -rouction levels"
4.8.!.2.2. 3ro(ution stoppages
5rouction $ay #e sto--e ue to a +ault in an ite$, a #reak<o!n in
e&ui-$ent, or a shortage o+ su--lies"
This $ay #e a -articularly signi+icant -ro#le$ +or continuous -rocesses,
although -rouction sto--ages $ay also a++ect #atch -rocesses"
The cost o+ a -rouction sto--age is generally $uch greater than the actual
ti$e o+ -rouction that is lost"
In so$e +acilities an ite$s o+ e&ui-$ent, a consiera#le cost is involve in
the -rocess o+ actually starting or sto--ing -rouction"
Also, this $ay elay other stages in the -rocess, an isru-t the general +lo!
o+ -rouction !ithin the +acility"
The nu$#er an length o+ -rouction sto--ages $ay #e eter$ine #y the
o-erating conition o+ the e&ui-$ent, an the -rouction -rocesses that are
in -lace"
A -rocess that is #uilt on e&ui-$ent an -roceures that -rouce lo! +ault
rates $ay have a lo!er rate o+ -rouction sto--ages than alternative
-rocesses"
4.8.!.2.3. -aintenane & replaement
Inustrial e&ui-$ent generally inclues a e+ine set o+ regular $aintenance
-roceures, as s-eci+ie #y the $anu+acturer"
Also, re-airs an non<scheule $aintenance $ay #e neee on a regular
#asis !ith co$-le3 ite$s o+ e&ui-$ent"
Maintenance can #e a signi+icant e3-ense in so$e $anu+acturing o-erations"
=o!ever, e&ui-$ent that is not -ro-erly $aintaine $ay loose -rouction
ca-acity ra-ily, an lea to a $a9or ecline in o-erating e++iciency"
***
In aition to re-lacing consu$a#le ite$s an other scheule $aintenance,
a9usting $achines regularly $ay lea to reuce +ault rates, -revent
e3cessive !ear an e3ten the use+ul !orking li+e o+ the e&ui-$ent"
%&ui-$ent that has reache the en o+ its use+ul !orking li+e $ay e3-erience
+re&uent sto--ages, high +ault rates an re&uire high levels o+ $aintenance"
%&ui-$ent shoul generally #e re-lace !hen its o-erating -er+or$ance
#egins to eteriorate signi+icantly"
4.8.!.2.4. 3ro(ut mi)es
In $ost $anu+acturing o-erations, a range o+ i++erent -roucts are $ae"
%ach -rouct $ay have i++erent $argins, an $ay re&uire a i++erent set o+
ra! $aterials"
The $i3 o+ i++erent -roucts that are $ae uring a -erio $ay a++ect the
net results +or the -erio"
In $any cases, the custo$er e$an $ay eter$ine the $i3 o+ -rouction
that is -er+or$e uring a -erio"
=o!ever, other o-tions coul inclue -roucing a large #atch o+ a -rouct to
#e sol at a iscount, an reucing or increasing the -rices o+ iniviual
-roucts to lea to a $ore e++ective $i3 o+ -rouction"
4.8.!.2.5. 'vailabilit$
Although -rouction levels have a signi+icant i$-act on costs an net -ro+it,
the level o+ -rouction is e-enant on t!o issues"
The ca-acity utilisation is the nu$#er o+ ite$s -rouce, as a -ercentage o+
the ca-acity o+ the +acility"
In the short ter$, -rouction levels $ay #e eter$ine #y custo$er e$an
+or the -roucts"
=o!ever, -rouction $ay also #e a++ecte #y the availa#ility o+ the +acilities"
**)
Availa#ility re+ers to the -ercentage o+ ti$e that a -rouction +acility !as
o-erational an availa#le +or use, !hether or not -rouction actually
occurre"
A lo! availa#ility rate $ay -lace a li$it on -rouction volu$es, regarless
o+ the level o+ custo$er e$an"
I+ custo$er e$an e3ceee the availa#le su--ly o+ -roucts an
signi+icant elays !ere involve in shi--ing -roucts to custo$ers, then the
availa#ility rate $ay #e a signi+icant issue"
7o!n<ti$e involves a -erio o+ ti$e in !hich a +acility is not availa#le +or
use"
This $ay occur +or so$e o+ the +ollo!ing reasons"
Break<o!n in e&ui-$ent that re&uires re-airs"
Scheule $aintenance"
Sto--ages ue to a +aulty ite$"
Sto--ages ue to a lack o+ su--lies"
In general the -rouction $anage$ent -rocess shoul atte$-t to $ini$ise
-erios o+ unavaila#ility, -articularly uring -erios o+ high sales e$an"
The availa#ility rate can #e calculate using the +ollo!ing +or$ula
100
house production potential total
use production for available hours
rate ty availabili
2or e3a$-le, i+ the total hours o+ o-eration !ithin a -erio !ere 1,000 hours
an the +acilities !ere availa#le +or use +or 630 hours, then the availa#ility
rate coul #e calculate using the +ollo!ing e3a$-le
100
1000
630
rate ty availabili
**8
63
4.8.!.2.!. /ault rates
Although the natural +ault rate o+ a syste$ is a -rouct o+ the esign o+ a
syste$, +ault rates are also an o-erational issue"
A stage in the -rouction -rocess that generates a high +ault rate $ay lea to
+re&uent sto--ages o+ that stage an other stages, increase the level o+ $anual
in-ut re&uire, an reuce the &uality level o+ the +inishe -rouct"
7e-ening on the situation, high +ault rates $ay #e aresse #y re-lacing
!orn<out ite$s o+ e&ui-$ent, changing the orer an structure o+ tasks an
-rocesses, an aressing +ault rates as a -rouction issue along !ith
volu$es, availa#ility rates an $aterials usage"
The +ault rate can #e calculate using the +ollo!ing +or$ula
produced items of number total
produced items faulty of number
rate fault
In this calculation, the :nu$#er o+ +aulty ite$s -rouce; $ay inclue the
+ollo!ing ite$s"
Ite$s -rouce that are +aulty or $is<+or$e"
Machines 9a$$ing, causing a #reak in -rouction"
Ite$s -rouce that are outsie the esign tolerances +or the
-rouct"
2or e3a$-le, a -rouction run $ay involve the +ollo!ing results
**1
'olu$e -rouce 1,000
2aulty ite$s -rouce )
Ite$s outsie tolerances 23
Machine 9a$s . sto--ages 2
Total +aults 31
1000
31
rate fault
.1 3
4.8.!.2.7. 4nventor$ management
Inventory inclues ra! $aterials hel +or -rouction, an +inishe goos
store +or shi-$ent to custo$ers or istri#utors"
Inventory $anage$ent involves recoring ite$s hel !ithin inventory,
$anaging inventory levels, an orering su--lies"
,arge $anu+acturers $ay store thousans o+ i++erent ite$s !ithin $aterials
inventories, an s$all $anu+acturing o-erations $ay also have co$-le3
inventory arrange$ents"
Capital & inventor* levels
Inventory $ust #e +une, ho!ever stocks an +inishe goos that are store
o not earn a return"
2or e3a$-le, e#t $ay #e raise to +un inventory an on<going interest
-ay$ents $ay #e $ae, although no inco$e !oul #e receive +ro$ the
ite$s hel in storage"
The costs involve !ith inventory storage $ay also inclue lease or ca-ital
costs o+ storage +acilities, insurance, an the eterioration o+ ite$s hel in
storage"
**6
2or these reasons, the level o+ inventory is generally ke-t at the lo!est
-ractical level"
=o!ever, sto--ing -rouction ue to a lack o+ su--lies $ay lea to
signi+icant -rouction losses, an in general the inventory levels shoul #e
$aintaine at su++icient levels to -revent -rouction sto--ages !herever
-ossi#le"
$ecords & ordering
Inventories are generally $anage using co$-uterise inventory
$anage$ent syste$s"
These syste$s $ay recor the nu$#er o+ ite$s that are hel +or each
$aterial, the rate o+ usage, an re<orering arrange$ents"
Arers $ay #e -lace !ith su--liers on a regular #asis, or as stocks #eco$e
lo!"
%lectronic links $ay #e use in so$e cases to $anage orering arrange$ents
+or su--lies"
In so$e cases, inventory an -rouction $anage$ent $ay #e integrate into
a single so+t!are syste$"
In other cases, se-arate syste$s $ay #e use"
5rouction $anage$ent so+t!are $ay store -rouction recors an generate
re-orts regaring scheuling, -rouction volu$es, $argins, usage o+
$aterials an so on"
Storage
A consiera#le a$ount o+ storage s-ace $ay #e re&uire to store $aterials,
an -articularly +inishe goos"
So$e $anu+acturing takes -lace !ithin inner<city areas, !here lan area has
a high cost"
In these cases, s$all a$ounts o+ +re&uently<use $aterials $ay #e ke-t at the
-rouction site, !ith a large !arehouse o+ su--lies ke-t at another location"
*)0
Darehouse s-ace can #e lease on a te$-orary or -er$anent #asis, or lan
can #e -urchase an !arehouse +acilities $ay #e constructe"
4.8.!.2.8. 3ro(ution emplo$ees
Manu+acturing involves e$-loying sta++ to o-erate $achinery, loa
$aterials, an trans-ort stocks"
This !oul generally involve a co$#ination o+ -er$anent, contract an
te$-orary e$-loyees"
5er$anent sta++ are use !hen a etaile kno!lege o+ the -rouction
-rocess is re&uire"
/ontract an te$-orary sta++ are use to $anage changing -rouction levels
ue to seasonal e$an an changes in sales levels"
Although e$-loy$ent arrange$ents !ith -er$anent sta++ can #e ter$inate
uring sustaine -erios o+ slo! sales, $anaging sta++ing levels is $ore
-ractical !hen contract an te$-orary arrange$ents are use"
4.8.!.2.9. E)essive fous on effiien$
In so$e res-ects, the #ase line +or -rouction e++iciency coul #e consiere
to #e 100L, !ith +igures less than this re-resenting a reuction +ro$ the
re+erence -oint"
2or e3a$-le, $aterials usage o+ 61L i$-lies that 2L o+ $aterials !ere
!aste, !hile a ca-acity utilisation o+ 1*L i$-lies that 1*L o+ the -otential
-rouction volu$e !as not use"
=o!ever, in so$e cases atte$-ts to increase e++iciency an reuce !astage
$ay #e counter<-rouctive"
2or e3a$-le, retaining ol an !orn<out e&ui-$ent, an using su--lies that
have egrae in an atte$-t to avoi !astage an save costs $ay to lea to
an increase in costs an !astage, rather than a reuction"
All $anu+acturing o-erations involve a -ro-ortion o+ !astage !hich $ust #e
!ritten o++ in orer to $aintain e++icient o-erating -rocesses"
*)1
In general, any ste- that changes the +una$ental nature o+ an o-eration an
that i$-roves e++iciency $ay #e a -ositive evelo-$ent"
=o!ever, a level o+ !astage is a natural -art o+ e++icient o-erations, an
atte$-ts to retain every last ro- o+ value +ro$ su--lies or e&ui-$ent are
likely to lea to a reuction in e++iciency, rather than an increase"
4.8.!.3. 4nreasing volume apait$
Increase -rouction ca-acity $ay #e re&uire !hen the #usiness
e3-eriences strong sales e$an, or !hen e3-ansion into ne! $arkets
occurs"
Increasing -rouction ca-acity itsel+ oes not auto$atically lea to a higher
level o+ sales"
=o!ever, increasing ca-acity $ay allo! sale -rices to #e reuce to increase
the nu$#er o+ sales, !hich $ay inirectly i$-rove returns"
Also, $any o+ the ste-s that $ay #e involve !ith increasing ca-acity $ay
also lea to a general i$-rove$ent in the e++iciency o+ the -rouction
-rocess, an lea o+ lo!er costs, regarless o+ the volu$e that is actually
-rocesse"
4.8.!.3.1. E9uipment & proess (esign
The ca-acity o+ a -rouction +acility is e-enant on the e&ui-$ent that is
use, an the -rocesses that are esta#lishe"
In so$e circu$stances, changing the -rouction -rocesses $ay ena#le a
higher rate o+ -rouction to #e generate"

2or e3a$-le, a $achine $ay have a ca-acity o+ 10,000 units -er hour, !ith
storage s-ace +or *,000 units o+ ra! $aterials"
In this situation, the $achine coul only o-erate continuously +or hal+ an
hour using a single set o+ su--lies"
I+ a long $anual -rocess !as involve in $oving su--lies an loaing
$aterials into the $achine, then the total -rouction level over a -erio o+
ti$e $ay #e +ar lo!er than the rate ca-acity o+ the $achine"
*)2
So$e $achines can #e re<stocke !hile they are o-erating, ho!ever the si@e
o+ the storage an the ti$e involve in loaing su--lies $ay #e a $a9or
+actor a++ecting the -rouction rate an the costs o+ the -rocess"

%3a$-les such as this coul #e aresse using a--roaches such as
increasing the storage ca-acity o+ the in-ut an out-ut storage, linking
$achines irectly together, an changing the loaing -rocess so that su--lies
coul $ore easily #e trans-orte an loae into a $achine"
4.8.!.3.2. Balane( proess stages
I+ one stage in a -rouction -rocess is consiera#ly slo!er than the other
stages, the cost an ca-acity o+ the other stages $ay #e !aste"
The s-ee o+ -rocessing through the -rouction stages is set #y the slo!est
stage, !ith any e3cess ca-acity in other stages re$aining unuse"
=igh costs $ay occur ue to the unuse ca-ital cost o+ the e&ui-$ent an
+acilities in the other stages"
In general, regarless o+ the ca-acity o+ a -articular +acility, each stage
shoul #e #alance to have a si$ilar ca-acity to the other stages, to reuce
costs that $ay #e associate !ith unuse +acilities"
This -ro#le$ $ay -articularly arise in situations !here a large nu$#er o+
changes have #een $ae to a +acility over a -erio o+ ti$e, rather than a
+acility #eing evelo-e as a single -ro9ect"
In these cases, a !ie variety o+ i++erent $achines o+ varying ca-acity an
age $ay #e in -lace"
5rouction -rocesses $ay have change $any ti$es since the +acility !as
+irst esta#lishe"
In this situation, costs $ay #e $ini$ise i+ atte$-ts are $ae to ensure that
each stage su--orts a si$ilar ca-acity to the other stages, an that a ca-ital
e3-eniture #uget is irecte to!ars u-ating the -rouction stages that
have the least ca-acity"
*)3
4.8.!.3.3. Bottlene6s
The ca-acity o+ a -rouction -rocess $ay #e restricte #y a #ottleneck in the
-rocess"
In these cases, re$oving the #ottleneck $ay lea to a large increase in
ca-acity"

In a -rouction -rocess that involves $any stages in se&uence, the ca-acity
o+ the -rocess is set #y the slo!est stage in the -rocess"
A #ottleneck $ay severely reuce the through-ut o+ a -rocess that !oul
other!ise have a $uch greater volu$e ca-acity"
Bottlenecks $ay occur ue to so$e o+ the +ollo!ing reasons"
A !orn<out ite$ o+ e&ui-$ent !ith slo! -rouction an a high
level o+ o!n<ti$e"
An ite$ o+ e&ui-$ent that is rate at a lo!er ca-acity than other
stages in the -rocess"
A -rouction stage than involves a high level o+ $anual in-ut, an
that coul either #e re-lace #y $achine -rocessing, reesigne to
#e $ore e++icient, or have a greater ca-acity through aitional
resources"
5oor co<orination an scheuling, !here one stage +inishes an a
long elay occurs until a se-arate -arallel stage is co$-lete, so that
the ne3t stage o+ -rouction can co$$ence"
4.8.!.3.4. E)pan(ing apait$
%3-aning ca-acity $ay involve re-lacing e&ui-$ent !ith higher<ca-acity
$achines"
This is a se-arate issue to re-lacing out<ate or !orn<out $achines,
although in -ractice the t!o issues $ay #e linke together in the -urchase o+
a ne! ite$ o+ e&ui-$ent"
*)0
/a-acity can #e e3-ane #y scra--ing the e3isting e&ui-$ent an
-urchasing a ne! $achine, or #y continuing !ith the e3isting $achine an
-urchasing a s$aller ne! $achine to e3ten the total ca-acity"
Re-lacing a single $achine !ith a single larger $achine !oul generally
lea to higher e++iciency an lo!er costs than o-erating t!o $achines in
-arallel"
Also, this a--roach $ay #e necessary !hen the e3isting $achine !as -ast its
use+ul !orking li+e an !as not in a conition to ena#le e++icient -rouction
to continue"
=o!ever, in cases !here the e3isting $achine !as o-erating e++ectively an
higher ca-acity !as re&uire, there $ay also #e avantages in o-erating a
ne! $achine in -arallel !ith the e3isting +acilities"
This $ay re&uire aitional costs in $aintenance an rent +or +loor s-ace"
Also, the e++iciency that !oul #e achieve at +ull -rouction levels $ay #e
lo!er than the e++iciency that !oul #e achieve #y using a single large
$achine"
=o!ever, this a--roach $ay #e $ore e++icient at lo! -rouction volu$es, as
in so$e cases a s$all $achine that o-erates near +ull ca-acity $ay use +e!er
resources than a larger $achine o-erating at a s$all -ro-ortion o+ esign
rating"
Also, this arrange$ent $ay allo! +or a #ack<u- +acility arrange$ent, !here
one $achine coul #e use to allo! -rouction to continue i+ the other
$achine !as unavaila#le ue to $aintenance or a #reak<o!n"
The ca-ital cost o+ the ne! $achine $ay also #e lo!er that a re-lace$ent
a--roach, !hen the e3isting $achine -rovie a signi+icant -ro-ortion o+ the
total increase volu$e ca-acity"
4.8.!.4. 7tilising pro(ution apait$
The e++ective o-eration o+ a $anu+acturing #usiness $ay involve t!o relate
issues"
This $ay involve esta#lishing an e++icient -rouction +acility, an then using
the +acility e++ectively to -rouce -roucts +or custo$ers"
*)*
Sales e$an is o+ little relevance i+ the -rouction +acilities su++er +ro$
serious -ro#le$s"
Also, an e++icient -rouction +acility is o+ little use unless custo$er e$an
+or the -roucts occurs"
The success o+ a $anu+acturing #usiness is e-enant on +ully utilising the
ca-acity o+ the -rouction +acilities that are create"
4.8.!.4.1. -ar6eting
In cases !here +acilities are not +ully utilise, $arketing activities coul #e
increase as a $etho o+ increasing sales"
This coul involve avertising an -ro$otion ca$-aigns, $arketing in ne!
regions such as interstate an overseas, an arranging istri#ution !ith ne!
istri#utors"
Hnlike so$e activities such as retailing an istri#ution, the cost o+ a
$anu+acture -rouct is not a +i3e value"
This cost changes !ith the level o+ -rouction"
This can lea to a situation !here sales are lo! #ecause costs an -rices are
high, ho!ever the costs an -rices are high #ecause the sales level is lo!"
Ane o-tion +or aressing this -ro#le$ $ay #e to reuce sale -rices in
avance o+ a $a9or -ro$otion ca$-aign"
Although early sales $ay generate a loss, the increase volu$e +ro$ a
success+ul e3-ansion $ay restore the $argins to their -revious level, at a
high level o+ sales than the -revious situation"
=o!ever, this a--roach $ay only #e -ractical !hen the -rice has a irect an
signi+icant i$-act on the nu$#er o+ sales"
4.8.!.4.2. 3ro(uts
Most $anu+acturers -rouce a range o+ -roucts"
*))
This $ay range +ro$ several $a9or -roucts, through to thousans o+
iniviual -roucts"
%ach -rouct !ill have a i++erent $argin an $ay re&uire i++erent
e&ui-$ent an ra! $aterials"
7iscontinuing -roucts that $eet !ith little e$an +ro$ custo$ers $ay
have several #ene+its"
This $ay allo! the -rouction ca-acity to #e use to -rouce larger volu$es
o+ $ore -o-ular -roucts, !hich $ay also lo!er the costs o+ the $ore
-o-ular -roucts"
Also, carrying a -rouct has a !ie range o+ costs, incluing issues such as
co$-le3 -rouct catalogues, inventory storage, e&ui-$ent setu- +or
-rouction, co$-uter -rocessing o+ ata an so on"
In the case o+ lo!<volu$e -roucts, iscontinuing a -rouct $ay increase the
e++iciency o+ the -rouction o-eration"
In cases !here the -rouct line has not #een u-ate +or a -erio o+ ti$e,
esigning an launching ne! -roucts $ay lea to an increase in sales"
Also, e3isting -rouct esigns $ay nee to #e u-ate to $eet changing
interests +ro$ custo$ers"
In the case o+ s-are -arts +or iscontinue -roucts, these $ay #e
$anu+acture !hile a steay level o+ sales e$an continues"
Dhen sales +all to a lo! level, one o-tion $ay #e to organise a large
-rouction run +or the -art"
The -arts coul then #e -lace in storage, together !ith any tools, $ouls
an s-eci+ications, an re$ove +ro$ the general $anu+acturing inventory
an o-eration lists"
This -rocess $ay allo! a storage o+ -arts to #e ke-t +or several years to $eet
-arts re&uests, an -ossi#ly +or ecaes, !ithout the costs involve in
$aintaining a large nu$#er o+ unuse -roucts !ithin the o-erational
-rouct lists"
*)8
4.8.!.4.3. #easonal businesses

Seasonal inustries have the $a9ority o+ their sales are certain ti$es o+ the
year"
This $ay #e !eather<e-enant, such as !inter skiing e&ui-$ent, or
calenar<e-enent, such as retail sales uring 7ece$#er"
In these cases, -rouction $ay continue through the year, !ith +inishe
goos #eing store +or elivery"
This a--roach has the avantage that a steay rate o+ -rouction can #e
$aintaine through the year, !hich $ay allo! $ore e++icient -rouction"
=o!ever, in cases !here te$-orary +acilities can #e hire, lo!er costs $ay
#e achieve #y organising a large volu$e o+ -rouction over a -erio o+ a
+e! $onths, rather than $aintaining +acilities through the +ull year"
Storage o+ +inishe goos $ay -resent a -ro#le$ !hen a large volu$e o+
storage s-ace is re&uire, or !hen the goos are -erisha#le, such as +oo
ite$s"
In these cases, continuing -rouction through the +ull year $ay not #e
-ractical"
Alternatives $ay inclue arranging -rouction +or several $onths, an using
-rouction ca-acity uring the other $onths to -rouce a i++erent range o+
-roucts, or to -er+or$ contract $anu+acturing +or other #usinesses"
4.8.!.4.4. +$lial businesses
/yclical inustries have large variations in activity +ro$ one -erio to the
ne3t"
2or e3a$-le, the construction inustry $ay have several years o+ high
activity, +ollo!e #y several years o+ very little activity"
A-erating in a cyclical inustry $ay -resent a i++iculty +or the $anage$ent
o+ an e++ective $anu+acturing o-eration"
This coul #e aresse in a nu$#er o+ -ossi#le !ays"
This $ay inclue so$e o+ the +ollo!ing -oints"
*)1
/onstructing s-lit +acilities, so that -arts o+ a +acility coul #e close
uring -erios o+ slo! sales"
Hsing hire an te$-orary e&ui-$ent uring -erios o+ high sales
e$an"
,aunching a secon -rouct range that !as sol in a i++erent
inustry, an !as not a++ecte #y the sa$e cycle as the $ain
inustry"
5er+or$ing contract $anu+acturing +or other #usinesses"
4.8.!.4.5. #plit failities
S-lit +acilities involves the use o+ several s$aller $achines rather than a
single large $achine"
Also, this $ay involve u-licating a -rocess in several sections !ithin a
+acility, so that each section coul #e o-erate as a co$-lete -rouction
+acility, or all sections coul #e o-erate to generate the $a3i$u$
-rouction out-ut uring -erios o+ high e$an"
This -rocess $ay allo! s$all volu$es to #e -rouce at lo!er costs that the
costs involve !ith o-erating a large +acility at lo! volu$es"
5art o+ the +acility $ay #e o-erate at close to +ull ca-acity, an the
alternative +acilities coul #e -lace on a general $aintenance #asis uring
ti$es o+ lo! sales e$an"
4.8.!.4.!. +ontrat manufaturing
/ontract $anu+acturing involves -roucing goos +or other #usinesses"
This coul inclue short<ter$ arrange$ents to $eet seasonal e$an or to
su--ly ca-acity to #usinesses e3-eriencing -rouction -ro#le$s"
Alternatively, longer<ter$ arrange$ents $ay a--ly to #usinesses that o not
o-erate their o!n -rouction +acilities, or to #usinesses that are e3-aning
an have insu++icient in<house ca-acity to $eet sales e$an"
*)6
This arrange$ent $ay allo! the #usiness to s$ooth cash +lo!s across
-erios, continue -rouction levels !hen sales are lo!, an generate inco$e
!ithout the costs associate !ith -rouct evelo-$ent, $arketing an
istri#ution"
4.8.!.5. +apital e)pen(iture (eisions
A ecision to -urchase a ne! ite$ o+ e&ui-$ent or to construct a ne! +acility
$ay #e a $a9or #usiness ecision"
The cost o+ inustrial e&ui-$ent $ay #e high in co$-arison to the cash +lo!
an cash resources o+ the #usiness"
/a-ital e3-eniture ecisions $ay involve re-lacing an iniviual $achine,
or constructing an entirely ne! +acility"
Machine re-lace$ent $ay occur every ten or +i+teen years, !hile large scale
$anu+acturing +acilities generally o-erate largely unchange +or several
ecaes #e+ore they are re<#uilt"
The ecision to re-lace an ite$ o+ e&ui-$ent $ay involve a revie! o+ the
current e&ui-$ent in use"
This $ay involve recoring so$e o+ the +ollo!ing in+or$ation
The +ault rate over a -erio o+ ti$e"
The -ercentage o+ o!n<ti$e"
The $aintenance costs"
The volu$e ca-acity o+ the $achine"
The -rouction volu$e that can #e achieve, allo!ing +or the ti$e
involve in setting u- an su--lying the $achine"
The current e-reciation e3-ense, i+ any"
The interest -aya#le on e#t that !as e&ual in si@e to the $arket
value o+ the $achine" This !oul #e the interest saving that coul #e
achieve #y selling the $achine"
*80
Si$ilar +igures coul #e esti$ate +or a ne! $achine"
A co$-arison coul then #e one #et!een the e-reciation an interest
e3-enses associate !ith the ne! $achine, an the cost savings ue to lo!er
$aintenance, less o!n<ti$e, an higher -rouction volu$es co$-are to
the e3isting $achine"
=o!ever, the e++ect o+ each stage on the total -rouction -rocess shoul also
#e consiere"
In general, $aintaining an e++icient +lo! through o+ every stage in the
-rouction -rocess $ay have #ene+its +or the #usiness #eyon the irect
$easure cost o+ an iniviual ite$ o+ e&ui-$ent"
#et present value
In the case o+ larger scale +acilities, a net<-resent<value -ro9ect valuation $ay
#e conucte"
This $ay involve esti$ating the inco$e over the e3-ecte li+e o+ the +acility,
assu$ing a certain rate o+ gro!th in sales, in+lation, volu$es an so on, an
co$-aring the -resent value o+ the inco$e !ith the ca-ital cost o+ the
-ro9ect"
*81
2or e3a$-le, the +ollo!ing +igures $ay #e use as assu$-tions to value a
-ro9ect"
Initial sales value 10,000
Sales gro!th rate * L -"a"
5ro+it Margin 10 L (constant over ti$e)
5ro9ect iscount rate 1* L
%sti$ate +acility li+e 20 years
;ear #ales =et 3resent
:alue 3rofit :alue
1 1"?""" 1?""" 87"
2 1"?5"" 1?"5" 794
3 11?"25 1?1"3 725
4 11?57! 1?158 !!2
5 12?155 1?21! !"4
! 12?7!3 1?27! 552
7 13?4"1 1?34" 5"4
8 14?"71 1?4"7 4!"
9 14?775 1?477 42"
1" 15?513 1?551 383
11 1!?289 1?!29 35"
12 17?1"3 1?71" 32"
13 17?959 1?79! 292
14 18?85! 1?88! 2!!
15 19?799 1?98" 243
1! 2"?789 2?"79 222
17 21?829 2?183 2"3
18 22?92" 2?292 185
19 24?"!! 2?4"7 1!9
2" 25?27" 2?527 154
Total =et 3resent :alue 8?379
*82
The -resent value o+ a +igure re-resents the e&uivalent value o+ a +uture cash
+lo! on the current ate"
5resent values are iscusse in etail in the section on +inance, #eginning on
-age 820"
In this e3a$-le, the total -resent value o+ +uture yearCs -ro+its over the li+e o+
the -ro9ect !oul #e e&uivalent to 1,386 at the current ate"
In this case, i+ the -ro9ect coul #e constructe at a lo!er cost than this
+igure, then the -ro9ect !oul have a -ositive net return, other!ise
constructing the +acility !oul #e a loss<$aking transaction"
This a--roach is generally use to value large -ro9ect evelo-$ents"
Ather issues $ay also #e involve, such as the costs an returns o+ e3isting
+acilities, the -lans +or +uture irections an -roucts o+ the #usiness, an so
on"
aluation multiples
A -ro9ect valuation coul also #e calculate using a $ulti-le, such as a
$ulti-le o+ the current net -ro+it"
This a--roach $ay #e -articularly relevant to a +acility that !as alreay
o-erating"
2or e3a$-le, -ro9ects o+ a si$ilar ty-e $ay #e value at aroun 1"* ti$es the
current year -ro+it"
In this case, the -ro9ect value coul #e esti$ate using the +ollo!ing
e3a$-le"
profit year current multiple valuation value pro*ect
1000 * 1 .
1*00
*83
4.8.!.!. E)pansion & improving returns
4.8.!.!.1. +ommo(it$ pro(uers
/o$$oity -roucts are ite$s that are sol in large volu$es o+ si$ilar
ite$s"
This inclues agricultural -roucts an $ining -roucts"
Inustrial co$$oities inclue che$icals, -a-er, steel, an har!are
co$-onents +or co$-uters"
%lectricity generation an oil re+ining coul #oth #e consiere to #e
co$$oity -rouction activities"
/o$$oities are -rouce in large volu$es, an generally trae in o-en
$arkets"
5rices in these circu$stances +all to the lo!est sustaina#le level, #ase on
current -rouction technology"
%cono$ies o+ scale $ay #e the $a9or +actor in the e++ective o-eration o+ a
co$$oity $anu+acturing o-eration"
In general, the latest -rouction technology $ust #e use, an ca-ital
e&ui-$ent in these $anu+acturing +acilities $ay #e u-ate on a regular
#asis"
5a-er $ills, steel $ills an har!are $anu+acturers generally o-erate !ith
very high -rouction ca-acities, continuous -rouction -rocesses, an
e++icient -rouction"
In the case o+ co$$oity -roucers, a s$all range o+ stanar -roucts is
generally -rouce in high volu$es"
5rices o+ #oth in-ut an out-ut ite$s are generally set #y e3ternal +orces"
In these situations, i$-roving returns $ay #e #ase on increasing volu$es,
or reucing costs through ca-ital invest$ent in the latest technology an
large<scale -rouction e&ui-$ent"
*80
4.8.!.!.2. #peialist pro(uers
S-ecialist -roucers -rouce a !ie range o+ various -roucts"

In these cases, -roucts $ay vary !iely +ro$ one $anu+acturer to another"
5rouct esign, evelo-$ent an $arketing $ay #e i$-ortant issues in these
o-erations"
The e++iciency o+ -rouction an the sale -rice o+ the +inishe goos $ay #e
less critical in these cases than in the case o+ co$$oity -roucers"
=o!ever, increasing -rouction e++iciency $ay i$-rove returns, as in $any
cases the volu$e o+ sales that can #e generate $ay #e li$ite #y the !ie
variety o+ other -roucts that are also availa#le in the $arket -lace"
4.8.!.!.3. 8arge mar6et s.ares
7ue to the ca-ital<intensive nature o+ $anu+acturing an the econo$ies o+
scale that can #e generate, it is co$$on +or an inustry to consoliate into
t!o or three $a9or -roucers"
In these cases, e3-ansion !ithin the inustry $ay #e i++icult"
Although lo!ering -rices to increase sales $ay #e e++ective in $arkets !ith
$any co$-etitors, in the case o+ concentrate $arkets, a irect res-onse
+ro$ the co$-etitors $ay occur, !ith -rice reuctions #eing irectly
$atche"
In this case, returns !oul #e reuce an sales $ay not increase"
Invest$ent in ne! ca-ital e&ui-$ent, i$-le$enting ne! technology, an
u-ating -rocesses $ay i$-rove returns"
=o!ever, in the case o+ concentrate inustries, the $ain o--ortunity +or
e3-ansion $ay involve entering ne! $arkets"
This $ay involve selling e3isting -roucts in ne! areas, such as overseas
$arkets, or launching a ne! -rouct range !ithin a ne! inustry"
*8*
4.8.!.7. E)ample pro(ution reports
The +ollo!ing +or$ats -resent so$e o+ the in+or$ation that coul #e inclue
in -rouction re-orts"
5rouction re-orts $ay o+ten contain large volu$es o+ in+or$ation"
The +or$ats #elo! a not intene as s-eci+ic +or$ats, #ut illustrate the ty-e
o+ in+or$ation an calculations that coul #e use+ul in $anaging -rouction"
(>> calculate -ercentages etc" in is-laye +igures)
9nits
Produced
Varia0le
Cost
Sale
Price
Production
6argin
2ixed
Cost
Allocation
Sale
6argin
Capacit" Capcit"
9sed
Product A (-11 %:-% %:#1 (%; %:-1 #;x (%%% *-;
Product < %(-1 1:-1 %:1- #; %:-1 ,:&; %--- (%;
Product C -%-1% (:-1 &:%- (&; %:-1 (%; (%(% #&;
6arch April 6a" =une >uarter Same
!uarter in
Pre4ious
?ear
?ear Change
since last
"ear
Product A (-11 %-1% %-1% %-1% &1--1 -1-1& (%%% @ (%;
Product < %(-1 1-1% %-1 #; %:-1 ,:&; %--- A (1;
Product C -%-1% %-1- &1-& (&; %:-1 (%; (%(% @ 1-;
6arch April 6a" ?ear Last ?ear
/otal Plant Bours (%-1 (%-1 (%-1 (%-11- (%-11-
Do+ntime
Scheduled 6aintenance 1- -& -1& 1&- -1&
Other Schedule Processes -1& 1& -1 &1 -1&
9nscheduled Stoppages -1& -& -1& &1 -%,
Stoppages due to suppl"
shortages
%-1 -1% ,& *, -1&
/otal Do+n /ime %-11 -%1 &1- ,1& -1&
A4aila0le Bours 1-1 %-1 -1%1 %-1 %-1
A4aila0ilit" .#; #%; .-; ,-; .1;
Production Bours -1( %-1( -1( %(-1 -1(
*8)
A4aila0le Bours 9sed %-; -%; %-; -%; %-;
6arch April 6a" ?ear Last ?ear
Income %-1 -%1& &1- -1& -1
Expense for fixed costs -1& &-1& -1 -& %-
Expenses for 4aria0le costs *, -1& -1-1 -1 %-
A4aila0le <illa0le Bours (%-1 (%-1 (%-1 (%-11- (%-11-
Bours <illed %-11 %-1% %-11 %-1% 1%-1
Proportion of hours 0illed %-; %-; *&; 1&; %-;
2ixed cost per hour 0illed -:1- 1:-1 -:-- 1:1- %-:1-
2ixed costs at max: hours
0illed
%:1- %:1- %:&1 &:1-1 -:1-
5lant Htilisation +or Se-te$#er
5rouction /a-acity 123000
5rouction 23213
2i3e /osts 23232
2i3e /ostsJHnit 1"32
2i3e /ostJHnit 1"12
at $a3 ca-acity
Margin 8L
Margin 6"*L
at $a3 ca-acity
*88
4.8.7. +reating a manufaturing business
Markets +or $anu+acture -roucts can generally #e escri#e as either
co$$oity $arkets or s-ecialty $arkets"
/o$$oity $arkets involve large volu$es o+ a s$all nu$#er o+ -roucts,
an inclue e3a$-les such as -a-er, steel an consu$er electrical goos"
These $arkets are generally su--lie #y a s$all nu$#er o+ $anu+acturers
o-erating -lants !ith high -rouction volu$es an large econo$ies o+ scale"
S-ecialty $arkets inclue a !ie range o+ goos that are sol in s$aller
volu$es, !ith $any i++erent -rouct esigns #eing use"
/o$-eting e++ectively in a co$$oity $arket !oul re&uire raising a large
su$ o+ ca-ital an constructing a high<ca-acity +acility"
A-erating a s-ecialty $anu+acturing o-eration can #e i$-le$ente as a s$all
start<u- o-eration, #eginning !ith li$ite volu$es an e3-aning as sales
are increase"
Manu+acturing o-erations have an avantage over so$e other +or$s o+
#usiness activity, in that sa$-les can #e $ae an -resente to -otential
custo$ers #e+ore the o-eration co$$ences"
In contrast, the $arket e$an +or so$e activities, such as service
#usinesses, cannot #e e++ectively eter$ine until a+ter the #usiness #egins
o-erating"
A start<u- $anu+acturing o-eration $ay co$$ence !ith sa$-les, $ock<u-s
or $oels, -rouce using $anual $ethos, an use to e$onstrate the
-rouct ieas to -otential custo$ers"
5rouction $ay co$$ence !ithin han<$ae activities in so$e cases, !hile
in other cases so$e lo!<volu$e e&ui-$ent coul #e lease or -urchase to
co$$ence o-erations"
The esign, costs an -ricing o+ the -roucts $ay #e i$-ortant in these
circu$stances"
%3a$-les o+ -ossi#le -roucts $ay inclue so$e o+ the +ollo!ing ite$s"
Hnusually esign -roucts"
*81
Tools an e&ui-$ent +or ne! inustries, !hen the e&ui-$ent has
#een aa-te +ro$ other uses an is not irectly suita#le +or the
-ur-ose that it is #eing use +or"
4e! -roucts !here the e3isting $anu+acturers su--lying -roucts
have !ithra!n +ro$ -rouction, $ove into i++erent inustries, or
not u-ate their -rouct esigns +or long -erios o+ ti$e"
5roucts esigne +or s-eci+ic -ur-oses, in cases !here general<
-ur-ose -roucts are currently use"
5roucts esigne +or s$all target $arkets, !here large
$anu+actures o not currently su--ly s-eci+ic -roucts"
The general -attern o+ evelo-$ent o+ a $anu+acturing #usiness $ay involve
co$$encing !ith a s$all scale o-eration, -roucing a li$ite nu$#er o+
-roucts an sourcing sales !ithin a li$ite area"
I+ -roucts !ere !ell receive an $et !ith steay sales e$an, then
+acilities coul #e e3-ane in stages, through the -urchase or leasing o+
higher<ca-acity e&ui-$ent, an through using $achinery +or -rocesses that
!ere -reviously -er+or$e $anually"
This -rocess $ay #e associate !ith reuce costs an sale -rices, e3-ansion
into !ier areas, an -ossi#ly e3-ansion o+ the nu$#er o+ -roucts into a
!ier -rouct range"
In the case o+ e3-aning +acilities an lo!er costs -er unit, sales volu$es
$ay also increase !ithin e3isting $arkets ue to the lo!er -rices that $ay #e
o++ere"
This e3-ansion -rocess !oul generally re&uire signi+icant ca-ital, !hich
coul #e +une through #ank loans, through +uns source +ro$ the e3isting
#usiness o!ners or other investors, or through leasing arrange$ents"
4.8.8. T.e evolutionar$ proess 5it.in manufaturing
I$-rove$ents in technology $ay allo! -roucts to #e $anu+acture using
+e!er ra! $aterials than -revious -rocesses"
As ti$e goes #y, ne! technology $ay #e i$-le$ente an $ay result in
larger an $ore e++icient +acilities"
*86
The si@e o+ -rouction +acilities, the -rouction ca-acity, an the ca-ital
costs $ay all increase"
/onversely, the a$ount o+ $anual in-ut, the ti$e re&uire to -rouce an
ite$ an the ra! $aterials use +or each ite$ $ay ecrease as this
evelo-$ent un+ols"
The evolution o+ $anu+acturing -rocesses allo!s -roucts to #e create in
higher volu$es, at lo!er costs -er unit than -revious -rocesses"
This tren $ay occur !ithin the econo$y generally, !ithin s-eci+ic
inustries, an !ithin iniviual #usinesses that e3-an in si@e or that
increase -rouction e++iciency"
4.8.9. -isellaneous manufaturing issues
4.8.9.1. #pare parts
S-are -arts $ay #e a signi+icant issue in several situations !ithin
$anu+acturing"
,nternal e)uipment
Su--lies o+ s-are -arts +or e&ui-$ent that is use #y the #usiness $ay #e
necessary to ena#le regular $aintenance to #e -er+or$e, an to re-air
e&ui-$ent +ollo!ing #reak<o!ns"
In $ost cases, s-are -arts !oul #e source +ro$ the e&ui-$ent
$anu+acturer, or +ro$ thir<-arty $anu+acturers, as they !ere re&uire"
In the case o+ e&ui-$ent that !as iscontinue #y the $anu+acturer, or !hen
the $anu+acturing #usiness cease to o-erate, kee-ing internal stores o+ s-are
-arts $ay #e use+ul in avoiing long<ter$ -ro#le$s !ith o#taining -arts"
Also, this a--roach $ay allo! $aintenance an re-airs to #e conucte at
less cost an in shorter -erios o+ ti$e than i+ -arts nee to #e source
e3ternally"
*10
Products
5arts +or $anu+acture e&ui-$ent are generally su--lie irectly to
istri#utors, in aition to the co$-lete -roucts, +or use in service an
re-airs"
5roucing s-are -arts, in aition to -roucing co$-lete -roucts, $ay #e a
signi+icant -art o+ a $anu+acturing o-eration"
S-are -arts inventories $ay contain thousans o+ i++erent ty-es o+ ite$s,
an involve co$-le3 storage, orering an inventory control arrange$ents"
Availa"ilit*
In the case o+ large ite$s o+ e&ui-$ent !ith long e3-ecte o-erating
li+eti$es, the +uture availa#ility o+ s-are -arts $ay #e a signi+icant issue in a
custo$erCs ecision to -urchase a -rouct"
Although this $ay not #eco$e a $a9or issue in the case o+ sta#le
$anu+acturing o-erations !ith long histories, in other cases this issue $ay
#eco$e signi+icant"
2or e3a$-le, in a situation !here there !as signi+icant ou#t a#out the
continue o-eration o+ the #usiness, custo$ers $ay ecline to -urchase
-roucts ue to the risk that -arts $ay not #e availa#le in the +uture"
Many ite$s o+ e&ui-$ent have e3-ecte li+eti$es that $ay e3cee 1* years,
an in so$e cases these -roucts !oul #e una#le to o-erate i+ a s$all -art
!as not availa#le +or re-lace$ent"
As another issue, this situation $ay result in the esta#lish$ent o+ a steay
strea$ o+ sales #eing i++icult +or a ne! or a s$all $anu+acturer o+ ca-ital
e&ui-$ent, !here custo$ers $ay avoi the -roucts ue to the risk o+ long<
ter$ -arts availa#ility"
This issue $ay #e aresse in various !ays"
Ane o-tion $ay #e to esta#lish an escro! -arts inventory, !ith s-are -arts
#eing -rouce an store in !arehouse +acilities, an o!ne an $anage
#y another -arty such as a co$$ercial trustee"
In the event o+ a #usiness li&uiation, the -arts inventory $ay #e $aintaine
se-arately an taken over #y another o-erator, to ena#le a long<ter$ -arts
su--ly to #e $aintaine"
*11
In so$e cases, a single ite$ o+ e&ui-$ent $ay #e esigne an constructe"
2or e3a$-le, a $anu+acturer $ay co$$ission the esign an construction o+
a s-eci+ic $achine to -er+or$ a certain o-eration in the $anu+acturing
-rocess"
In these cases, a set o+ s-are -arts $ay also #e create along !ith the
co$-lete $achine, to allo! +or regular $aintenance an +uture re-lace$ent"
The engineering esigns $ay also #e su--lie !ith the $achine, to ena#le
-arts to #e create in the +uture as re&uire"
Parts designs
In cases !here $anu+actures cease to o-erate or are li&uiate, it is co$$on
+or other -arties to take over the -rouct esigns o+ the $anu+acturer, an to
continue the $aintenance an s-are -arts su--ly o+ the -revious -roucts"
This $ay #e one #y another -arty -urchasing the esigns an the rights to
the -rouct irectly +ro$ the #usiness itsel+, or through the li&uiation
-rocess as -art o+ the sale o+ the #usinessCs assets"
A no$inal +ee !oul nor$ally #e involve, as in $any cases the li&uiation
itsel+ $ay have #een relate to a lo! volu$e o+ sales, an the ne! o-erator
$ay si$-ly -er+or$ $aintenance an su--ly activities +or the -roucts that
!ere alreay in use"
*12
4.8.1". #ummar$ of manufaturing issues
/a-ital assets Manu+acturing is a ca-ital<intensive, asset<#ase
activity" %&ui-$ent an +acilities are use to -rouce
goos +or sale" The return on assets +igure, !hich
gives the -ercentage -ro+it return on the asset #ase,
re-resents the -ercentage return +ro$ the
$anu+acturing o-eration itsel+, ignoring interest
costs an e#t leverage"
7e-reciation %&ui-$ent eclines in value over ti$e" This
e-reciation e3-ense re-resents a loss o+ value" The
net -ro+it uring a -erio is the net cash +lo!, $inus
the loss o+ value ue to e-reciation"
7esign .
Manu+acturing
5rouct esign is a -ro9ect<#ase activity, !hile
$anu+acturing is a continuous activity" In cases
!here -rouct esign is a large #usiness e3-ense, the
+inancial analysis $ay s-lit the esign costs +ro$ the
$anu+acturing o-eration, !ith licence +ees allocate
+or the $anu+acturerCs use o+ -rouct esigns"
%cono$ies o+
scale
In general, the cost -er unit o+ -rouction is lo!er
+or high ca-acity e&ui-$ent an +acilities than +or
lo! ca-acity e&ui-$ent an +acilities" This e++ect
also occurs !ith -rouction levels !ithin an e3isting
+acility"
2i3e . varia#le
costs
Manu+acturing costs $ay inclue +i3e costs -er
-erio, such as lease -ay$ents an e-reciation, an
varia#le costs, such as the ra! $aterials use in
-rouction" A high -ro-ortion o+ +i3e costs $ay #e
associate !ith high ca-acity +acilities an high
levels o+ auto$ation" A high -ro-ortion o+ +i3e
costs $ay result in a high leverage o+ net -ro+it to
rises or +alls in sales levels"
Technology Technology is a $a9or issue in $anu+acturing" This
inclues ne! avances in e&ui-$ent esign, ne!
techni&ues, an u-ate -rocesses" Technology an
econo$ies o+ scale $ay #e the t!o $a9or +actors in
eter$ining the -otential e++iciency o+ a
$anu+acturing o-eration"
'olu$es The volu$e o+ goos -rouce is relevant to the
results an -er+or$ance o+ a $anu+acturing
o-eration, in aition to +inancial +igures" In
-articular, the ca-acity utilisation, !hich $easures
the -rouction volu$e as a -ercentage o+ the
*13
+acilityCs -otential -rouction level, $ay have a
signi+icant i$-act on the net -ro+it results"
*10
4.8.11. #ummar$ of manufaturing alulations
4.8.11.1.1. 3ro(ution
100
production potential of hours tota
use for availabile hours
rate ty availabili
100
capacity volume design
produced units of number
n utilisatio capacity
produced items of number
used material of volume
item per usage materials
100
used material of volume
products finished in material of volume
efficiency usage materials
time do(n average time run average
time run average
capacity machine capacity production
+

produced items of number total
produced items faulty of number
rate fault
5rocess ti$e +or a series -rocess P su$ o+ the ti$es +or each stage
5rocess ti$e +or a -arallel -rocess P $a3i$u$ ti$e +or a single
stage
*1*
4.8.11.1.2. 3lant struture
100
+

ts cos labour on depreciati

on depreciati
level automation
items of number
item each of age the of sum
age e!uipment average
100

machines of number total
machines ng depreciati non of number
e!uipment ng depreciati non
100

ts cos ia0le 4ar total
e!uipment ng depreciati non 0" used ts cos ia0le 4ar
e!uipment ng depreciati non
ts cos occupancy building
assets facilities & e!uipment
ensity int capital ocupancy
ts cos occupancy building
profit net
n utilisatio occupancy
*1)
4.8.11.1.3. /i)e( & variable osts
unit per t cos iable var unit per price sale
ts cos fixed
volume sales even brea$

units num
ts cos fixed
unit per t cos fixed
n utilisatio capacity volume design
t cos fixed
unit per t cos fixed

units num
ts cos fixed
unit per t cos iable var unit per t cos +
n utilisatio capacity volume design
t cos fixed
unit per t cos iable var unit per t cos

+
( )
( ) ts cos fixed t cos iable var unit price sale unit units num
t cos iable var unit price sale unit units num
leverage production

*18
4.8.11.1.4. -argins
( )
unit per price sale
unit per t cos iable var unit per price sale
in arg m production

( )
unit per price sale units num
ts cos fixed unit per t cos iable var unit per price sale units num
in arg m sales

4.8.11.1.5. ,eturns
assets
tax & erest int before earnings
assets on return
ratio t cos fixed n utilisatio capacity in arg m production capacity sales "#A
Ter$s +or the return on assets +or$ula
assets
volume design
price sales capacity sales
assets
ts cos fixed
ratio t cos fixed
capacity volume design
produced units of number
n utilisatio capacity
*11
4.8.11.1.!. 3rofit
( ) ts cos fixed unit per t cos iable var unit per price sale sales num profit net
ts cos fixed value sales in arg m production profit net
( ) ts cos fixed capacit" design n utilisatio capacit" unit per t cos ia0le 4ar unit per price sale profit net
4.8.11.1.7. /un(ing struture
( ) rate erest int debt "#A
g
g
"#A "#E

+
1
g P gearing ratio
RAA P return on assets
RA% P -re<ta3 return on e&uity
4.8.11.1.8. Beig.te( 'verages
(eights the of sum
item each for ' (eight amount ' the of sum
average (eighted

*16
"... Strategic planning & revie% activities
A strategic -lanning an revie! -rocess $ay involve a -erioic set o+
iscussions a$ong a tea$ or a grou- o+ -eo-le"
This $ay occur at various ti$es, although revie!s once every year or t!o
$ay #e a ti$e +ra$e that $ay #e suita#le +or long ter$ iscussions in so$e
circu$stances"
A strategic revie! $ay #e use to clari+y an !ork through a large nu$#er
o+ current -ro#le$s, an also to eter$ine a $eiu$ ter$ irection +or the
o-eration an the evelo-$ent o+ the activity"
4.9.1. Oasions
Strategic revie!s $ay occur at various ti$es, !hich $ay inclue so$e o+ the
+ollo!ing -oints"
Scheule revie!s, such as an annual revie! an -lanning -rocess"
2ollo!ing a $a9or $ilestone, such as the co$-letion o+ a large
-ro9ect, or a start<u- enter-rise reaching a sta#le -ositive cash +lo!
-osition"
7uring ti$es !hen $a9or issues $ay arise, that $ay a++ect the
o-eration an irection o+ the activity, an !hich $ay involve
etaile iscussions an $a9or ecisions"
Dhen a large nu$#er o+ issues arise an +uture irections see$
unclear"
In the case o+ reaching a $a9or $ilestone, a -erio o+ ti$e $ay ela-se
+ollo!ing the co$-letion ate or the occurrence o+ the event"
2ollo!ing a -erio o+ ti$e a+ter the co$-letion -erio, thoughts $ay #e
gathere an the -rocess o+ iscussing +uture irections $ay #egin"

*60
4.9.2. 8oation & struture
4.9.2.1. 8oation
A strategic revie! -rocess $ay #e assiste #y holing the iscussions !ithin
a i++erent location to the usual #usiness o-erations"
This $ay involve a se-arate #uiling, a con+erence centre, or other venues
such as a hotel +unction roo$s"
In the case o+ revie!s covering several ays, a resiential location $ay also
#e use"
This $ay involve a con+erence location that inclues acco$$oation an
$eals, !here the iscussions $ay #e $ove to a co$-letely se-arate location
+or a nu$#er o+ ays"
4.9.2.2. 1roup siAe
Strategic revie!s $ay o-erate e++ectively !hen they involve a grou- o+
#et!een a--ro3i$ately si3 an t!elve -eo-le"
A grou- o+ three or +our $ay +in that iscussions $ay #e little i++erent than
the iscussions that $ay occur irectly !ithin a #usiness environ$ent,
although the -rocess o+ +or$alising the iscussions $ay still #e use+ul"
In the case o+ grou-s that are larger than a#out 1* -eo-le, grou- iscussion
$ay not #e -ractical, an the event $ay #eco$e si$ilar to a &uestion an
ans!er lecture +or$at, !hich $ay not #e -rouctive to the evelo-$ent
-rocess"
4.9.2.3. 1roup in(ivi(uals
A revie! $ay involve a single tea$ that $ay o-erate a -articular activity
!ithin the #usiness structure"
In other cases, a grou- $ay involve re-resentatives +ro$ several i++erent
sections !ithin the #usiness, such as the heas o+ various e-art$ents"
*61
Strategic -lanning -rocesses $ay also #e hel #y #oars o+ irectors, an #y
#usiness o!ners an iniviuals +ro$ the #usiness in the case o+ other
#usiness structures"
In so$e cases, a tea$ $ay #e asse$#le involving various iniviuals, as
-art o+ a $a9or transaction, such as -re-aring a #i +or a large tener"
4.9.2.4. Time frames
A strategic revie! $ay o-erate +or t!o or three ays"
A $ini$u$ o+ a +ull ay $ay #e re&uire, an longer ti$e -erios $ay #e
necessary to +ully !ork through long ter$ issues"
Revie!s lasting $ore than a !eek $ay egenerate into iscussions that $ay
revolve in circles, covering the sa$e issues re-eately, !ith the grou-
$e$#ers #eco$ing very tire, an !ith little aitional -rogress #eing $ae
+ollo!ing a +ull !eek o+ iscussions"
4.9.3. Topis
7iscussions $ay involve a !ie range o+ to-ics"
This $ay inclue so$e o+ the +ollo!ing ite$s
A su$$ary an revie! o+ -rogress that has #een $ae,
evelo-$ents !hich have occurre, an $a9or events +ro$ the
-revious year or t!o"
5ossi#le +uture irections, incluing o--ortunities, -ro#le$s, an
issues relate to each -ossi#le irection"
A revie! o+ the current #usiness situation, such as resources, current
activities, an a revie! o+ the current structure an o-erations"
A iscussion o+ current -ro#le$s, o-tions an alternatives +or
aressing current -ro#le$s, an ste-s an actions that $ay #e
taken"
*62
4.9.4. 3reparation
A #roa agena an list o+ to-ics $ay #e -re-are #e+ore the revie! is
conucte"
%ach iniviual tea$ $e$#er $ay then -re-are notes an collect their
thoughts on the various issues that $ay #e involve regaring each to-ic +or
iscussion"
4otes an $aterials such as overhea slies $ay #e -re-are +or -resenting
in+or$ation to the grou-, such as a su$$ary revie! o+ $a9or activities an
events, an lists o+ o-tions +or +uture irections"
4.9.5. Organisation & operation
4.9.5.1. +o*or(ination
A strategic revie! activity $ay -rocee s$oothly in $any cases !here a
s-eci+ic iniviual is no$inate to coorinate activity an iscussions"
This $ay involve an iniviual such as a tea$ leaer or a chie+ e3ecutive
o++icer"
In the case o+ several iniviuals +ro$ i++erent areas, -ro#le$s $ay
so$eti$es arise in organising iscussions"
Atte$-ts $ay #e $ae to organise activities on a co<o-erative #asis,
ho!ever in $any cases this situation $ay not o-erate e++ectively"
In so$e situations a struggle $ay evelo- to control the iscussion -rocess,
!hile in other situations the o--osite case $ay occur, !ith no coorination
occurring, an to-ics not #eing e++ectively raise or issues #eing aresse as
intene !ithin an agena or the conte3t o+ the -lanning -rocess"
In this situation, a single iniviual $ay #e no$inate at rano$ to
coorinate the iscussion -rocess"
In so$e cases, -ro+essional +acilitators, or iniviuals e3-erience in the
evelo-$ent -rocess, $ay #e use to coorinate iscussions"
This $ay #e relevant in cases such as large grou-s, case !here hostility $ay
e3ist #et!een internal areas o+ the #usiness, an so on"
*63
4.9.5.2. #truture
In general, a rough agena o+ to-ics $ay #e +ollo!e"
%ach to-ic $ay #egin !ith a -resentation to the grou- #y an iniviual,
su$$arising key -oints an issues that $ay #e involve in the to-ic"
2ollo!ing this, general iscussion $ay occur"
In so$e cases, a to-ic $ay #egin !ith general iscussion, rather than an
iniviual -resentation"
Several hours o+ iscussion $ay #e necessary in orer to raise the relevant
issues an !ork through the issues through the iscussion -rocess"
Su$$arising issues an o-tions on a chart or is-lay #oar $ay #e use+ul
uring the iscussion -rocess"
The iscussion -rocess itsel+ $ay #e e3tre$ely use+ul in evelo-ing ieas
an o-tions, an !orking through e3isting -ro#le$s"
In so$e cases, a s-eci+ic set o+ actions $ay also #e ecie on as a result o+
the iscussion -rocess"
In general, each $e$#er o+ the grou- shoul have the o--ortunity to conuct
a -resentation, an -resent their throughs on a !ie range o+ issues, an
-ossi#ly also -resent in+or$ation relating to a s-eci+ic to-ic"
4.9.!. Outomes
A $a9or outco$e o+ the strategic revie! -rocess $ay involve a clearer
-icture o+ current -ro#le$s, the structure an o-eration o+ the #usiness, an
the irection +or evelo-$ent over the $eiu$ ter$"
S-eci+ically, outco$es o+ the revie! -rocess $ay inclue so$e o+ the
+ollo!ing ite$s"
A list o+ actions to #e taken to aress current -ro#le$s"
*60
A clear -icture o+ the irection +or activity over the $eiu$ ter$,
such as the ne! +e! years"
A -ossi#le list o+ ne! -ro9ects, changes to resources an activities,
an other issues relating to the #usiness activities to #e conucte
over a $eiu$ ter$ ti$e +ra$e"
4.9.7. 8arger groups
A relate revie! -rocess $ay also #e conucte #y larger grou-s"
This $ay involve grou-s o+ u- to aroun 100 -eo-le"
This $ay re-resent an entire organisation, or an iniviual e-art$ent,
ivision or #usiness unit o+ a larger organisation"
In the case o+ grou-s that $ay #e larger than this, the situation $ay evelo-
into a lecture ty-e o+ +or$at, !hich $ay not have a great eal o+ #ene+it as a
revie! -rocess"
In the case o+ a large grou-, the revie! -rocess $ay $ainly involve
-resentations #y iniviual tea$s, rather than iscussions"
A si$ilar location to tea$ revie!s $ay #e chosen, !ith a +ull ay #eing a
-ossi#le ti$e +ra$e +or the revie! -rocess"
%ach tea$ $ay conuct a -resentation, outlining $a9or activities an events
o+ the -revious year, current activities, an -lans an -ro9ects +or the $eiu$
ter$"
Throughs on general issues regaring the #usiness $ay also #e -resente"
Iniviual -ro#le$s $ay #e raise, although a +oru$ o+ this kin $ay not #e
a -rouctive situation to aress -ro#le$s, as a +ull iscussion o+ the issues
$ay not #e -ractical"
5ro#le$s $ay #e #est aresse !ithin tea$ iscussions, an in se-arate
iscussions #et!een iniviual areas"
A se-arate revie! #y the chie+ e3ecutive o++icer or hea o+ the #usiness unit
$ay also aress the o-erations an activities o+ the entire area, as a single
o-eration"
*6*
".10. $ro%th & (ecay
A #usiness $ay gro! through the actions that are taken #y the o-erators o+
the #usiness"
A #usiness is a yna$ic activity"
In the a#sence o+ continuous attention an ongoing $anage$ent, a #usiness
enters a natural state o+ ecay, an $ay graually ecline in si@e an
o-eration until it ceases to o-erate an closes"
The e++orts an ieas o+ the -erson or -eo-le $anaging an o-erating the
#usiness are the riving +orce that sustains the #usiness an creates the
e3-ansion o+ the #usiness enter-rise"
4.1".1. +apital investment
,ong<ter$ survival an e3-ansion o+ the #usiness re&uires regular invest$ent
in ne! -ro9ects"
This $ay involve -urchasing ne! e&ui-$ent or #uiling ne! +acilities,
evelo-ing ne! -roucts, evelo-ing co$-uter syste$s, an esigning ne!
-rocesses"
/a-ital invest$ent -ro9ects can #e +une +ro$ cash +lo! +ro$ the ongoing
#usiness o-erations, or ca-ital $ay #e source +ro$ raising e#t or +ro$
aitional e&uity invest$ent +ro$ investors"
4.1".2. Organi e)pansion
Arganics e3-ansion involves the gro!th o+ the #usiness +ro$ internal $eans"
This $ay involve e3-ansion into ne! $arkets, gro!th in sales an custo$er
nu$#ers, an evelo-ing ne! -roucts an services"
Arganic e3-ansion can #e riven #y the changes that occur in the #usiness
o-erations as ti$e goes #y, leaing to i$-rove use o+ technology, changes
to -rocesses an o-erations, an the evelo-$ent o+ econo$ies o+ scale as
custo$er nu$#ers increase"
*6)
Arganic gro!th can also #e erive +ro$ s-eci+ic -ro9ects, such as -rouct
evelo-$ent an esta#lishing o-erations in ne! geogra-hic regions"
4.1".3. '9uisition
(ro!th #y ac&uisition involves #uying other #usinesses"
This a--roach can #e use to enter ne! $arkets, to ac&uire technology that
!oul #e use+ul !ithin the e3iting #usiness, to reuce -er<unit costs through
larger volu$es, an to $ake large lea-s in si@e that !oul re&uire a long
-erio o+ ti$e or !oul si$-ly #e i$-ractical through graually increasing
custo$er nu$#ers"
(ro!th #y ac&uisition $ay involve -aying an aitional cost in the -urchase
o+ an e3isting #usiness"
Dhile in so$e case the ac&uisition o+ another #usiness $ay si$-ly involve
trans+erring custo$er accounts to the e3isting #usiness, in general this
-rocess $ay involve an e3tene -erio o+ ti$e an a is<organise structure
until a ne! structure is evelo-e +or the e3-ane #usiness"
4.1".4. Dea$
7ecay is the natural state o+ all non<living things"
Anything that is constructe or #uilt #egins to ecay +ro$ the $o$ent that it
is create
Aver ti$e, a -hysical o#9ect or other structure graually #reaks a-art, until it
#eco$es the #asic ra! $aterials that occur in nature, an that it !as #uilt
+ro$"
This occurs in the rusting an ecay o+ $achinery, the ecay o+ trees an
other -lant li+e, an in the ecay o+ #uilings an other structure"
This conce-t also a--lies to other constructe ite$s, such as #usinesses"
Dithout continual rene!al, a #usiness graually ecays"
*68
In a static #usiness o-eration, custo$er tastes an interests $ay change, #ut
the -roucts -rovie #y the #usiness $ay not #e u-ate"
4e! co$-etitors $ay a--ear !ith i++erent a--roaches, an custo$ers $ay
$ove to other su--liers"
Internal structures $ay also slo!ly +all a-art, an i++erent syste$s an
-rocesses $ay graually cease to o-erate"
This is a natural state o+ a++airs an can occur !hen a #usiness o!ner looses
interest in the #usiness o-erations, at ti$es +ollo!ing retire$ent, an !hen a
#usiness is o!ne #y -assive investors an e++ective $anage$ent is not in
-lace"
4.1".5. +apital starvation
/a-ital starvation occurs !hen ca-ital is not availa#le to conuct ne!
-ro9ects an invest$ent, an !hen costs are reuce to an unsustaina#le level
that results +uns #eing unavaila#le to -urchase essential su--lies, such as
in+or$ation su--lies"
This situation $ay occur in cases !here re-eate #uget reuctions have
#een a--lie to a #usiness o-eration +or an e3tene -erio o+ ti$e"
Also, this $ay occur !hen +uns are ina--ro-riately allocate"
2or e3a$-le, rather than using the availa#le +uns to evelo- a s$all
e++ective o-eration, the availa#le +uns $ay #e use to create or sustain a
larger o-eration, !hich cannot o-erate e++ectively using the availa#le
resources"
/a-ital starvation can result in an organisation #eco$ing -aralyse"
,arge sales $ay #e lost ue to s$all ite$s not #eing availa#le +or the
evelo-$ent o+ $arketing a--roaches an other activities"
Minor changes to -roucts $ay not #e -ossi#le, !hich $ay result in serious
o-erational -ro#le$s"
An organisation o-erating uner conitions o+ ca-ital starvation $ay
continue to o-erate !ith the current structures an o-erations +ro$ -revious
-erios"
*61
=o!ever, this $ay lea to a structure than graually #eco$es outate as
ti$e -rogresses, leaing to colla-se or large losses at so$e +uture ti$e"
Alternatives in this situation are to raise aitional ca-ital through e#t or
e&uity, increase o-erational #ugets, reuce the ivien strea$ !ithra!n
+ro$ the #usiness, or to restructure the #usiness to create a s$aller o-eration
that is a#le to $ove +or!ar e++ectively"
*66
#. Topics
#.1. Sourcing business services
5.1.1. +ontrat #ervies & pro%et (evelopments
/ontract services an -ro9ect evelo-$ents involves transactions !ith other
#usinesses regaring on<going services, as o--ose to #uying an selling
-roucts"
This $ay occur in a !ie range o+ circu$stances"
2or e3a$-le, contract services $ay #e use +or so$e o+ the +ollo!ing ty-es
o+ services"
A$inistration"
/o$-uter har!are . so+t!are su--ly, $aintenance an user
su--ort"
%&ui-$ent $aintenance"
Business services such as -ro-erty $anage$ent"
In this conte3t, contract services re+ers to an on<going service activity, rather
than iniviual transactions involving services such as legal services,
accounting services, avertising activities an so on"
5ro9ect contract evelo-$ent $ay involve the evelo-$ent o+ -ro9ects using
e3ternal contract arrange$ents"
2or e3a$-le, this $ay involve so$e o+ the +ollo!ing activities"
Builing construction"
/o$-uter so+t!are evelo-$ent"
%ngineering esign . testing o+ -rouct esigns"
A -ro9ect evelo-$ent generally involves a s-eci+ic task, !ith s-eci+ie ti$e
+ra$es an costs"
)00
In $ost cases an ite$ is -rouce #y the -ro9ect, although -ro9ects are also
conucte +or activities such as testing esigns, conucting large avertising
ca$-aigns an so on"
5.1.2. 4nternal vs. e)ternal servies
Service an -ro9ect evelo-$ents are arrange an $anage on a contract
#asis"
In the case o+ internal service areas, a service agree$ent $ay #e ter$e a
Service ,evel Agree$ent, !hile in the case o+ an e3ternal #usiness, a service
contract $ay #e in -lace"
A nu$#er o+ issues $ay #e relevant in $aking a ecision as to !hether to use
an e3ternal service -rovier, or to use or esta#lish an internal service area"
These $ay inclue so$e o+ the +ollo!ing issues"
5.1.2.1. Eonomies of sale
%3ternal service -roviers $ay o+ten -er+or$ services +or a range o+ clients,
an $ay conuct a larger nu$#er o+ transactions than the #usiness !oul
conuct irectly"
This $ay allo! the e3ternal #usiness to o-erate at lo!er costs than an
internal service area, ue to econo$ies o+ scale"
2or e3a$-le, the cost o+ co$-uter so+t!are -urchase or evelo-$ent coul
#e s-rea across a large nu$#er o+ transactions, !hile e&ui-$ent such as
high<ca-acity -rinters an $ail sorting $achines coul #e use"
The econo$ies o+ scale $ay allo! the e3ternal service to su--ly the services
at a lo!er cost than using an internal service o-eration"
5.1.2.2. :ariable volume levels
)01
The $a9or #ene+it !ith the use o+ e3ternal services $ay involve the a#ility to
increase or ecrease the volu$e o+ transactions that are -rocesse an the
costs that are incurre"
An internal service area $ay generally have a +i3e cost an ca-acity, !hich
coul not #e easily change in the short ter$"
7uring ti$es o+ slo! sales, the +i3e costs $ay re$ain even though the
ca-acity is unuse"
7uring ti$es o+ strong #usiness activity, the internal area $ay not have
su++icient ca-acity to $eet the nees o+ the #usiness activity"
In contrast, e3ternal service -roviers $ay charge on the #asis o+ the nu$#er
o+ transactions -rocesse, !ith +e! -ractical li$its on the $ini$u$ or
$a3i$u$ volu$e"
This arrange$ent $ay signi+icantly increase the +le3i#ility o+ the #usiness,
reuce the chance o+ losses uring slo! -erios, an allo! the #usiness to
o-erate e++ectively !hen sales e$an is high"
5.1.2.3. Termination an( ommenement
Service contracts $ay o+ten #e ter$inate or co$$ence at relatively short
notice"
In contrast, creating or closing an internal service area $ay involve a
consiera#le -erio o+ ti$e an a $a9or change to the #usiness structure"
The +le3i#ility o+ e3ternal services $ay allo! the #usiness to aa-t to
changing conitions an -ursue various -aths, such as iscontinuing
-roucts, launching ne! -rouct ranges, an so on"
5.1.2.4. 3roess 6no5le(ge
%3ternal services $ay not #e -ractical in cases !here a etaile kno!lege
o+ the #usiness structure an -rocesses is re&uire"
2or e3a$-le, the -re-aration o+ accounts an +inancial state$ents !oul
usually #e -er+or$e in<house"
)02
In the case o+ large service agree$ents, this -ro#le$ $ay so$eti$es #e
-artially overco$e #y iniviual sta++ $e$#ers !ithin the service -rovier
#eing involve solely !ith transactions relate to a single client"
5.1.2.5. 'vailabilit$
In so$e cases, e3ternal service -roviers are not availa#le to -er+or$ various
services, or the services that are availa#le $ay not $eet the service stanars
an cost structures that !oul #e esira#le in o-erating the #usiness"
In these cases, an internal service area $ust generally #e use, involving
either an e3isting service area, or creating a ne! service area"
5.1.2.!. 3ro%et resoures
Although the total a$ount o+ !ork involve in a -ro9ect is not a++ecte #y the
nu$#er o+ e$-loyees -er+or$ing the -ro9ect tasks, this issue $ay a++ect the
ti$e that is taken to co$-lete the -ro9ect"
,ong -ro9ects $ay lea to high interest costs, lost o--ortunities in the $arket
-lace, i++iculties !ith te$-orary arrange$ents, an the chance o+ -ro#le$s
evelo-ing ue to circu$stances changing uring the evelo-$ent o+ the
-ro9ect"
The use o+ e3ternal services $ay have a #ene+it in ter$s o+ the -ossi#ility o+
allocating a large nu$#er o+ resources to a -ro9ect +or a short -erio o+ ti$e,
rather than re&uiring a long -ro9ect evelo-$ent"
This a--roach $ay also #e use !ith internal evelo-$ent areas in so$e
cases"
A -ro9ect co$-lete on this #asis $ay #e co$-lete in a relatively short
-erio o+ ti$e, -articularly regaring the construction -hases rather than the
esign -hases"
7isavantages !ith this a--roach $ay inclue the li$ite ti$e availa#le to
correct esign -ro#le$s an change the course o+ the -ro9ect"
A risk $ay arise in these cases o+ a esign -ro#le$ #eco$ing +ro@en into the
structure o+ the co$-lete -ro9ect"
)03
Also, the structure o+ the co$-lete -ro9ect $ay #e -artially +or$e as the
construction a--ears, !ithout the o--ortunity +or revie! #y the client"
=o!ever, these issues $ay #e out!eighe #y the !ie range o+ -otential
#ene+its that $ay #e availa#le +ro$ a short -ro9ect evelo-$ent ti$e"
5.1.3. +omponents of a servie agreement
In so$e cases, service contracts an agree$ents $ay contain a large nu$#er
o+ iniviual -oints"
This !oul generally occur in the case o+ a large transaction, !here a
contract !as iniviually negotiate #et!een the service -rovier an the
client"
In the case o+ retail services that involve a large nu$#er o+ clients, such as
tele-hone services, a set o+ stanar -roucts an service levels !oul
generally #e availa#le, !ith a relatively straight<+or!ar +ee structure"
So$e o+ the s-eci+ic -oints that coul #e aresse $ay inclue the
+ollo!ing issues"
5.1.3.1. /ees
The +ee arrange$ents !oul nor$ally #e s-eci+ie, an coul inclue so$e
o+ the +ollo!ing +ee structures"
2i3e regular +ees"
2i3e transaction +ees, !ith the +ee level relate to the ty-e o+
activity involve in a -articular transaction"
Hsage +ees, !ith the +ee #ase on the a$ount o+ usage o+ ite$s such
as co$-uter ata, electricity, trans-ort services an so on"
Mini$u$ an $a3i$u$ +ees, an co$#inations o+ various +ee
arrange$ents"
)00
5ro9ect -ay$ents such as regular -ay$ents, -ay$ents !hen stages
!ere co$-lete or $ilestones !ere reache, -ay$ents at the en o+
the -erio an so +orth"
5.1.3.2. Time frames
A service contract $ay s-eci+y ti$e +ra$es, such as res-onse ti$es to
en&uiries, turn<aroun ti$es +or -rocessing s-eci+ic transactions an so on"
In the case o+ -ro9ects, a -ro9ect scheule $ay a--ly"
In $any cases this !oul #e a -erio o+ ti$e !ith a target -ro9ect co$-letion
ate"
In the case o+ large -ro9ect evelo-$ents, ti$e+ra$es $ay #e s-eci+ie +or
the co$-letion o+ various stages"
5.1.3.3. 3rogress revie5s
5rogress revie!s o+ -ro9ects $ay involve the client revie!ing the structure o+
the -rouct an the -rogress o+ the -ro9ect at various -oints in the
evelo-$ent"
This $ay #e one to ensure that the -ro9ect !as -roceeing accoring to the
scheule, an also to ensure that the esign o+ the ite$ $atche the esign
that the client !as e3-ecting"
A -rogress revie! $ay involve the #usiness as the client o+ a evelo-$ent
-ro9ect, or alternatively, the #usiness $ay #e involve in a -ro9ect revie! as
the -ro9ect evelo-er"
In the case o+ a -ro9ect evelo-$ent #usiness, this -rocess $ay reuce the
risk to the #usiness o+ is-utes a#out the esign arising a+ter a -ro9ect !as
co$-lete"
5.1.3.4. +osts
/osts that are incurre #y the service -rovier !hen -er+or$ing the services
+or the client $ay #e $anage in various !ays"
)0*
This $ay inclue so$e o+ the +ollo!ing alternatives"
/osts -ai #y the service -rovier, !ith the average cost level
inclue !ithin the service +ees"
/osts -ai #y the service -rovier an then rei$#urse #y the client"
/osts -asse on to the client +or irect -ay$ent #y the client"
5.1.3.5. 'u(its
Auits $ay #e involve !hen the service -rovier -rocesses +inancial
transactions on #ehal+ o+ the #usiness"
2or e3a$-le, a contract a$inistration services $ay -rocess custo$er
-ay$ents into a clientCs holing account, an $ake -ay$ents to en
custo$ers +or re+uns o+ creit account #alances"
Auits !oul nor$ally #e -er+or$e #y accounting an auiting +ir$s that
also auit the -re-aration o+ +inancial state$ents"
/usto$er service auits are -er+or$e #y e3ternal agencies to revie!
custo$er service stanars"
This $ay involve an e$-loyee o+ the agency -resenting anony$ously as a
custo$er o+ the #usiness, an rating issues such as -rouct kno!lege an
custo$er service a--roaches"
This $ay then involve a general assess$ent an rating o+ the custo$er
service stanars"
5.1.3.!. Data o5ners.ip? ontrol & ba6up
In so$e arrange$ents, a consiera#le a$ount o+ in+or$ation $ay #e store
#y the service -rovier"
2or e3a$-le, a service -rovier $ay store co$-uter recors o+ the #usinessCs
custo$er etails, transaction histories an so on"
This situation $ay raise a nu$#er o+ issues"
)0)
In cases !here the #usiness itsel+ i not store the in+or$ation se-arately, the
#ack<u- arrange$ents +or co$-uter ata storage $ay #e a signi+icant issue"
Also, security in ter$s o+ ata #eing -rovie to thir -arties, either
eli#erately or through unauthorise access, $ay also #e an issue"
In these cases, the contract $ay s-eci+y that any ata relate to the service
!as the -ro-erty o+ the #usiness, that ae&uate co$-uter #acku- +acilities
shoul #e in -lace, an that in+or$ation shoul not #e release !ithout
authorisation an shoul #e elete or trans+erre on re&uest"
5.1.3.7. Design o5ners.ip
The service contract !oul nor$ally s-eci+y the o!nershi- o+ any esigns
that !ere create as -art o+ the -ro9ect"
In the case o+ a s-eci+ic -ro9ect evelo-$ent, o!nershi- o+ the esign !oul
nor$ally rest !ith the client"
/usto$ esigne co$-uter so+t!are an gra-hic esign o+ -rouct logos
$ay #e e3a$-les o+ this situation"
In other cases, co-yright or esign o!nershi- $ay re$ain !ith the service
-rovier, !ith the service contract s-eci+ying license conitions"
2or e3a$-le, a -hotogra-hic assign$ent $ay #e conucte to -rouce
i$ages that $ay #e use in an avertising ca$-aign"
In so$e cases the co-yright o+ the -hotogra-hic i$age $ay re$ain !ith the
-hotogra-her, !ith the client having e3clusive use o+ the i$age +or a -erio
o+ ti$e +or -ur-oses such as an avertising ca$-aign"
5.1.3.8. ,eporting
A service agree$ent $ay inclue a escri-tion o+ various regular re-orts that
shoul #e -rovie to the client"
This $ay inclue in+or$ation such as inco$e a$ounts -rocesse, the nu$#er
o+ ne! custo$ers, an service res-onse ti$es"
)08
Re-orting $ay #e use +or t!o -ur-oses"
Regular re-orts $ay #e use to $onitor the service levels that !ere #eing
-rovie, an to ensure that the service levels i not +all #elo! the stanars
that !ere inclue in the service agree$ent"
Also, these re-orts an ata +ees $ay inclue in+or$ation that !as
necessary +or the $anage$ent o+ the #usiness itsel+, such as the cost an
inco$e a$ounts +or a -erio o+ ti$e"
5.1.3.9. 3enalties & (efaults
Default conditions
A e+ault conition is a situation in !hich a s-eci+ie -art o+ a contract is not
co$-lete"
This $ay inclue a s-eci+ie ter$ in the contract not #eing -er+or$e #y the
other -arty"
Also, large agree$ents co$$only inclue a list o+ e+ault conitions, such as
ti$e +ra$es +or -ay$ents o+ a$ounts that are ue, $ini$u$ service
stanars accoring to an ine-enent rating syste$, ti$e +ra$es +or -ro9ect
co$-letion an so on"
The actions that $ay result in each situation $ay also #e s-eci+ie"
2or e3a$-le, this $ay inclue actions such as +inancial -enalties, the right
+or the #usiness to !ithra! +ro$ the -ro9ect, the right to have -revious
co$-lete sections -urchase #y the other -arty at s-eci+ie values, an so
on"
Penalt* clauses
It is co$$on !ithin large agree$ents to inclue a range o+ e+ault
conitions, an -enalties that !oul a--ly in each case"
These $ay range +ro$ interest charges on overue -ay$ents, through to
ter$ination o+ the arrange$ent an +inancial -enalties i+ certain conitions
arose, such as a $a9or -ro9ect stage not #eing co$-lete !ithin a certain
ti$e+ra$e"
)01
These conitions $ay -articularly a--ly to -ro9ect evelo-$ents, an other
situations !here the #usiness coul su++er consiera#le loss i+ the other -arty
i not +ul+il the contract conitions"

The inclusion o+ -enalty clauses $ay reuce the risk to the #usiness o+
+inancial loss in various circu$stances, an also increase the chance that the
original contract conitions !ill #e +ul+ille #y the other -arty"
Minor -enalties, such as interest -ay$ents, $ay generally -ass !ith -ay$ent
#eing $ae an the contract continuing, !hile $a9or e+ault conitions $ay
result in court action as each -arty $ay atte$-t to $ini$ise the loss that !as
incurre in the situation that ha arisen"
%3a$-les o+ the secon conition $ay inclue a situation !here a large an
e3-ensive -rouct evelo-$ent -ro9ect !as conucte as a 9oint venture
#et!een t!o co$-anies, ho!ever the -ro9ect ene !ithout an e++ective
-rouct esign having #eing create"
#o-fault clauses
:4o<+ault; clauses s-eci+y conitions uner !hich -enalties $ay not arise"
These clauses $ay #e use in high<risk #usiness situations, !here there $ay
#e a signi+icant risk o+ +inancial loss occurring in the -ro9ect"
A no<+ault clause is inclue !ithin a contract to reuce the risk o+ other
-arties success+ully suing the #usiness in the event that a -ro9ect or activity
ene !ith losses occurring"
2or e3a$-le, a #usiness $ay enter a 9oint venture arrange$ent !ith another
#usiness to atte$-t the launch o+ a -rouct !ithin a ne! $arket"
A no<+ault clause $ay #e inclue in the agree$ent, to clearly s-eci+y that, in
the event that the -rouct launch !as unsuccess+ul, no aitional costs !oul
#e incurre #y the #usiness, an that the losses !oul #e li$ite to the
-ay$ents that ha alreay #een $ae"
5.1.4. Development of a servie agreement
In the case o+ stanar services, a set o+ -roucts an service levels !oul
nor$ally #e availa#le +ro$ the service -rovier"
)06
The #usiness !oul then select a -rouct +ro$ the service -rovier, an a
stanar service contract !oul a--ly"
Service contracts are so$eti$es -oste +or tener"
This !oul involve -u#lishing a notice o+ the o++er to receive tener
a--lications, together !ith a #asic escri-tion o+ the service an contract
etails +or the #usiness"
The #usiness $ay evelo- a co$-lete service contract that !oul #e
-rovie to allo! teners to #e su#$itte, or it $ay acce-t general
e3-ressions o+ interest !hich !oul lea to etaile negotiations"
In situations !here only a +e! service -roviers !ere availa#le, a #usiness
$ay contact a service -rovier irectly"
This $ay result in -urchasing a stanar service -rouct +ro$ the service
-rovier, or in the case o+ larger transactions, a -erio o+ negotiations $ay
take -lace"
5.1.5. -anaging a ontrat arrangement
%++ective $anage$ent o+ a service contract arrange$ent $ay involve
revie!ing regular re-orts, ensuring that auits !ere conucte, an
revie!ing auit re-orts"
In the case o+ an in+or$al service arrange$ent, aressing -ro#le$s $ay
involve iscussions !ith the service -rovier, an raising issues that neee
to #e aresse"
In these situations, the only o-tion availa#le to the client i+ -ro#le$s
continue $ay #e to co$-letely !ithra! +ro$ the service"
In the case o+ internal service -roviers, this $ay not al!ays -ossi#le, an
-ro#le$s $ay continue on an irregular an -er$anent #asis"
In the case o+ a etaile service level agree$ent, the #usiness $ay have the
o-tion o+ e3ercising -enalty clauses !hen e+ault conitions arose"
5enalty clauses !oul generally #e e3ercise #y e+ault"
)10
=o!ever, -enalties $ay so$eti$es #e !aive in situations !here an event
occurre that !as outsie the control o+ the service -rovier an !oul not
nor$ally #e -lanne +or"
A long #reak in the co$$ercial electricity su--ly $ay #e an e3a$-le o+ this
situation"
In the case o+ -ro9ect evelo-$ents, t!o $a9or issues arise"
The +irst is to ensure that the original s-eci+ications are lai out clearly an in
etail"
This $ay involve an initial list o+ re&uire$ents -re-are #y the #usiness,
!hich shoul generally cover all the $a9or issues involve"
The -ro9ect evelo-er $ay the -rouce a etaile esign #ase on the
re&uire$ents s-eci+ie #y the #usiness"
/onstruction shoul not co$$ence until the #usiness ha revie!e an
signe the co$-lete esign"
Also, regular revie!s o+ the -ro9ect -rogress, an the structure o+ the ite$ as
is it #uilt, $ay ensure that the -ro9ect re$ains on scheule, an that the ite$
that !as constructe $atche the esign that !as e3-ecte #y the #usiness"
5.1.!. Operating a servie or pro%et (evelopment business
A-erating a service or -ro9ect evelo-$ent #usiness $ay involve the general
issues o+ creating an evelo-ing a #usiness activity"
%cono$ies o+ scale $ay #e -articularly i$-ortant in these activities"
/lients !oul nor$ally acce-t services only !hen the cost o+ the service !as
lo!er than the cost that coul #e achieve #y using an e&uivalent in<house
service"
Also, so$e service inustries are highly co$-etitive, !ith a nu$#er o+
service -roviers su--lying si$ilar services, an -rice $ay #e a $a9or +actor
in the clientCs selection o+ a service -rovier"
/usto$er service stanars, res-onse ti$es an error rates $ay #e i$-ortant
issues !ithin a #usiness o+ this ty-e"
)11
These issues $ay irectly a++ect service contract conitions, an $ay they
$ay also a++ect the gro!th o+ the #usiness an the nu$#er o+ ne! clients
uring +uture -erios"
%++ective $anage$ent o+ the internal o-eration coul #e use to ensure that
these issues i not evelo- into -ro#le$s +or the #usiness o-eration"
#.. 3robability/ ris+ & statistics
5ro#a#ility involves issues concerning +uture events"
The +uture cannot #e -reicte"
In so$e cases, events $ay un+ol as one !oul e3-ect"
In other cases, a clear -ath o+ +uture events $ay see$ likely, an suenly an
event $ay occur that co$-letely erases all e3-ectations, an the likelihoo o+
-articular +uture circu$stances occurring"
%3-ectations o+ the +uture are o+ten that the +uture !ill #e si$ilar to the
-resent, !ith a +e! $inor changes"
In -ractice, events are o+ten highly une3-ecte !hen they occur"
Hne3-ecte events are a co$$on -art o+ the #usiness environ$ent, an
-lans, irections an -ro#a#ilities cannot -reict !hat !ill ha--en in the
+uture"
=o!ever, ecisions $ust #e $ae, an in so$e situations it !oul a--ear
that so$e events are $ore likely to occur than others"
5ro#a#ility involves a--lying $athe$atics to issues relating to the chance o+
-articular +uture events occurring"
Statistics involves analysing sets o+ nu$#ers"
This $ay inclue eter$ining -ro-erties o+ the set o+ nu$#ers, an
esti$ating the relationshi- #et!een i++erent sets o+ nu$#ers"

5.2.1. #ets of numbers
)12
5.2.1.1. #ingle variables
5.2.1.1.1. 'verages
5.2.1.1.1.1. #imple 'verages
An average o+ a set o+ nu$#ers re-resents a ty-ical or central -oint !ithin the
grou- o+ nu$#ers"
The $ost !iely<use $easure o+ an average is kno!n as the :arith$etic
average;"
In statistics this +igure is kno!n as the :$ean;"
The arith$etic average can #e calculate using the +ollo!ing +or$ula"
items of number
items individual the of sum
average
2or e3a$-le, the +ollo!ing ta#le -resents a set o+ cash +lo!s +or a t!elve
$onth -erio"

1"12
1""4
1"37
999
97"
1"23
952
1"39
1"2"
1"15
997
9!4
The average cash +lo! coul #e calculate using the +ollo!ing a--roach
)13
12
+,- ++/ 0102 0131 014+ +23 0134 +/1 +++ 014/ 011- 0103
average
+ + + + + + + + + + +

8 1002.
This +igure re-resents a central -oint !ithin the set o+ nu$#ers"
In this e3a$-le, this coul #e inter-rete as a cash +lo! that $ay #e receive
in a ty-ical $onth"
The total a$ount o+ an ite$ can #e calculate using the +ollo!ing +or$ula
items of number average total
2or e3a$-le, assu$ing that the cash +lo!s continue at the current rate, the
total cash +lo! over a t!o year -erio coul #e calculate using the +ollo!ing
e3a$-le"
20 8 1002 . total
0)0 20)
Averages can #e use to eter$ine the ty-ical +igure that $ay a--ly in a
#usiness situation"
In turn, these +igures coul #e use in calculations +or eter$ining +igures
such as $argins, an to eter$ine the current #usiness conitions"
2or e3a$-le, the $argin o+ sales to costs coul #e calculate using +igures
+or a +ull year"
=o!ever, a ne! -rouct launch or a change in o-erations $ay result in sales
sta#ilising at a ne! level"
In these circu$stances, a calculation using the average $onthly +igure +or
recent $onths $ay -rouce a $ore accurate esti$ate o+ current conitions
than using +igures #ase on the +ull year -erio"
)10
An average +ro$ a sa$-le can also #e use to esti$ate the total a$ount over
a larger range o+ ite$s, such as a longer -erio o+ ti$e, or a larger nu$#er o+
-roucts"
5.2.1.1.1.2. Beig.te( 'verages
In so$e situations, one nu$#er $ay have a higher or lo!er i$-act on an
average $easure than another nu$#er"
2or e3a$-le, a calculation $ay #e -er+or$e to eter$ine the average
interest rate across the e#ts o+ the #usiness"
In this case, the interest rate -ai on a large e#t !oul have a greater i$-act
on the e++ective interest rate than the rate -ai on a s$all e#t"
Situations such as this can #e aresse #y using a :!eighte average;
calculation"
In the conte3t o+ +inance an statistics, a :!eight; oes not generally re+er to
-hysical !eight"
In these conte3ts, the !eight o+ a nu$#er re+ers to the nu$#erCs signi+icance
or i$-act on the total a$ount o+ a set o+ nu$#ers"
The !eighte average can #e calculate using the +ollo!ing +or$ula"
amounts (eight the of sum
item each for ' (eight value ' of sum
average (eighted

2or e3a$-le, a #usiness $ay have the +ollo!ing three e#ts

A$ount Interest Rate
100 1
20 6
2* )"*
)1*
The !eighte average interest rate coul #e calculate using the +ollo!ing
e3a$-le
1* 20 100
* ) 2* 6 20 1 100
+ +
+ +

.
average
.6 8
The total a$ount o+ a +igure can #e calculate using the +ollo!ing +or$ula
(eights the of total average (eighted total
2or e3a$-le, the total interest -ai on the #usinessCs e#t coul #e calculate
using the +ollo!ing e3a$-le"
( ) 2* 20 100
100
6 8
+ +
.
total
0 11.
This illustrates that the !eighte average calculation eter$ines the e++ective
average o+ the set o+ nu$#ers"
Deights $ay o+ten #e -ercentages or -ro-ortions"
2or e3a$-le, i+ the inco$e +ro$ a #usiness o-eration !as erive +ro$ the
+ollo!ing three -roucts, then these -ercentages coul #e use as !eights to
eter$ine +igures such as the average costs +or each -rouct"
5rouct 5ro-ortion o+
Sales
5rouct A 10 L
5rouct B 8* L
)1)
5rouct / 1* L
In this case, -rouct B is the source o+ 8*L o+ the #usiness sales, an costs
relate to -rouct B $ay have a greater i$-act on the total costs o+ the
#usiness than costs that !ere relate to -rouct A"
5.2.1.1.1.3. 'lternative measures of t.e average
'arious other a--roaches are also taken to $easuring averages"
The :$oe; is the $ost co$$on single value occurring in a large set o+
si$ilar nu$#ers, although this +igure is rarely use in -ractice"
The :$eian; is the nu$#er !hich involves hal+ the ata set #eing larger
than the $eian, an hal+ the ata set #eing s$aller than the $eian"
The $eian can #e use+ul as a $easure o+ the average !hen a s$all sa$-le
o+ nu$#ers is availa#le, an !hen e3tre$e values $ay occur in the set o+
nu$#ers"
In these circu$stances, a single ata value $ay have a large i$-act on the
average, an the $eian $ay #e a $ore sta#le $easure o+ the central -oint
!ithin the ata set than the $ean"
The :geo$etric average; is use +or sets o+ nu$#ers that are $ulti-lie
together, such as invest$ent returns"
This is calculate using the +ollo!ing +or$ula
1
( <<<<<<<<<<<<<<<<<<<<<<)
R S nu$#er o+ ite$s
(eo$etric average P R-rouct o+ the ite$sS
R S
Aing the arith$etic average to itsel+ leas to the total o+ the ata set, !hile
$ulti-lying the geo$etric average #y itsel+ also leas to the total o+ the ata
set"
)18
The geo$etric average can #e use to re-resent a central -oint !hen the total
value o+ the ata set is eter$ine #y $ulti-lying, rather than aing, the
iniviual ite$s"
5.2.1.1.2. #tan(ar( (eviation
In aition to eter$ining the average o+ a set o+ nu$#ers, the variation
!ithin the nu$#ers can also #e $easure"
A set o+ nu$#ers that all have si$ilar values !oul have a s$all variation,
!hile a set o+ nu$#ers that !ere !iely i++erent !oul have a large
variation"
The $ost !iely use $easure o+ variation is kno!n as the :stanar
eviation;"
This is also use in the +or$ o+ the :variance;, !hich is e&ual to the stanar
eviation s&uare"
The stanar eviation can #e calculate using the +or$ula liste in the
+or$ula su$$ary #eginning on -age 1063"
Alternatively, this +unction $ay #e availa#le on -ocket calculators that
inclue statistical +unctions, an !ithin co$-uter so+t!are such as
s-reasheet -rogra$s"
The stanar eviation can #e thought o+ as the average istance that a ata
-oint is +ro$ the average value"
Technically, it is the s&uare root o+ the average o+ the s&uare i++erences"
In the case o+ the earlier e3a$-le, the +ollo!ing +igures !oul a--ly"
)11
1"12
1""4
1"37
999
97"
1"23
952
1"39
1"2"
1"15
997
9!4
'verage 1""2.7
#tan(ar( 28."
Deviation
In this case, the stanar eviation o+ the cash +lo!s has a value o+ 21"
In other ter$s, a ty-ical $onthly +igure $ay #e aroun 21 larger or s$aller
than the average o+ 1002"8"
2or e3a$-le, so$e ty-ical +igures coul #e calculate using the +ollo!ing
a--roach
deviation dard tan s average figure lo(
21 8 1002 .
8 680.
deviation dard tan s average figure high +
21 8 1002 + .
)16
8 1030.
Dhen stanar eviation is a--lie to a series o+ nu$#ers over ti$e, this $ay
#e inter-rete as the volatility o+ the -articular value"
2or e3a$-le, the volatility o+ a share -rice or a ra! $aterial -rice coul #e
calculate using a stanar eviation calculation"
A highly volatile -rice !oul have a high stanar eviation +igure, !hile a
sta#le -rice !oul have a lo! stanar eviation"
5.2.1.1.3. Time series
So$e ata series a--ly to a set o+ i++erent ite$s, !hile other ata series
a--ly to changes through ti$e"
2or e3a$-le, the cost -rices o+ a list o+ i++erent -roucts, or the value o+ a
set o+ assets, are #oth static sets o+ nu$#ers"
These nu$#ers coul #e analyse using the average an stanar eviation
calculations +ro$ the -revious section"
7ata series that a--ly through ti$e $ay inclue the -rice o+ ra! $aterials,
the sales receive in each -erio, asset values at i++erent -oints in ti$e an
so on"
These +igures can also #e analyse using averages an stanar eviations"
=o!ever, in the case o+ ti$e series, other issues $ay also a--ly"
2or e3a$-le, the unerlying average an volatility o+ the ata ite$s $ay not
#e constant"
In these cases, the unerlying average or stanar eviation o+ the ata ite$s
$ay change through ti$e"
These a++ects can #e revie!e #y calculating +igures #ase on a section o+
ti$e, an revie!ing the tren that occurs as the ata series -rogresses"
)20
5.2.1.1.3.1. Tren(s
In so$e cases the average or stanar eviation o+ a ata series $ay change
over ti$e"
2or e3a$-le, the average level o+ sales $ay steaily rise or +all over a long
-erio o+ ti$e, even through iniviual $onths $ay have high or lo! sales"
The +ollo!ing ta#le -resents the $onthly cash +lo!s +or a three<year -erio"
%ach average an stanar eviation +igure a--lies to the -revious t!elve
$onthly cash +lo!s"
In this e3a$-le, the #oth the average cash +lo! an the volatility o+ the cash
+lo!s has risen steaily over ti$e"
This e++ect $ay not #e clear +ro$ revie!ing the iniviual $onthly +igures,
as there $ay #e large rano$ rises or +alls +ro$ one $onth to the ne3t"
)21
-ont. +as. 12*mont. 12*mont.
/lo5 'verage #tan(ar(
Deviation
1 1"58
2 1132
3 1188
4 1175
5 1175
! 1377
7 1343
8 14"2
9 14"!
1" 1417
11 1584
12 15!! 1319 171
13 1!99 1372 182
14 1723 1421 191
15 1!47 14!" 18!
1! 1!51 1499 1!9
17 1853 155! 1!5
18 2125 1!18 222
19 1749 1!52 2"7
2" 2223 172" 248
21 1985 17!9 238
22 2"!5 1823 224
23 1859 1845 211
24 192! 1875 192
25 1922 1894 184
2! 2!58 1972 279
27 19!! 1999 2!"
28 2353 2"57 253
29 255! 211! 282
3" 2447 2142 297
31 227! 218! 272
32 2974 2249 355
33 2597 23"" 357
34 2!98 2353 3!!
35 2823 2433 354
3! 241! 2474 31!
)22
,verage & Stan(ar( Deviation
"
5""
1"""
15""
2"""
25""
3"""
35""
" 5 1" 15 2" 25 3" 35 4"
6onth
1
a
l
u
e
6onthl" Cash 2lo+s
(% month a4 erage
(% month standard de4iation
2igure *
The calculation o+ a tren average is kno!n in invest$ent analysis as a
:$oving average;"
This a--roach $ay also #e use+ul in #usiness analysis to highlight rising or
+alling trens in sales, $argins, costs an so on"
5.2.1.1.3.2. #easonal Data
In $any #usiness situations, +igures $ay vary accoring to the ti$e o+ the
year"
In these cases, trens over a short ti$e -erio, such as a +e! $onths, $ay
re+lect seasonal changes, rather than a change in the #usiness itsel+"
'arious statistical +or$ulas an a--roaches are use in atte$-ts to eter$ine
unerlying trens !ithin seasonal ata, -articularly in the case o+ econo$ic
ata"
)23
=o!ever, in $any -ractical #usiness circu$stances there $ay #e li$ite
in+or$ation than can #e eter$ine #y +ollo!ing these a--roaches"
7eter$ining a clear tren re&uires a reasona#le nu$#er o+ ata -oints, an in
the case o+ seasonal ata, an entire year $ay e++ectively +or$ a single ata
ite$"
In -ractice, the tren #eing $easure $ay change at a +aster rate than the
nu$#er o+ ata -oints that are availa#le to $easure it"
=o!ever, one a--roach in these circu$stances $ay #e to co$-are +igures
against the sa$e -erio in the -revious year, rather than co$-aring +igures to
-revious $onths"
This a--roach $ay #e use in -rouction re-orts, co$-aring sales +igures to
-revious -erios an so on"
Also, a tren $ay #e ienti+ie in so$e cases #y co$-aring each iniviual
$onth to the -revious year, an eter$ining the average change"
2or e3a$-le, the +ollo!ing ata -resents a set o+ seasonal sales +igures, !ith
the -ercentage change +ro$ the sa$e $onth in the -revious year also
inclue"
)20
-ont. #ales +.ange
1 11"3
2 1948
3 1392
4 191"
5 138"
! 1183
7 38"
8 52"
9 58"
1" 733
11 444
12 13!" 23<
13 17"1 *13<
14 19!3 41<
15 1558 *18<
1! 1!9" 23<
17 1!"2 35<
18 1"49 17!<
19 54! 5<
2" !"9 5<
21 413 *44<
22 2!2 *41<
23 91" *33<
24 1398 *18<
25 1!44 *1!<
2! 18"5 1!<
27 1513 *1"<
28 1!12 1<
29 17!7 !8<
3" 1142 1"9<
31 1154 9"<
32 8!! 11"<
33 4"8 5!<
34 243 *73<
35 11"3 *21<
3! 1198 *27<
'verage 18<
)2*
Seasonal sales figures
"
5""
1"""
15""
2"""
25""
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
6onth
1
a
l
u
e
2igure )
These sales +igures illustrate a seasonal -attern o+ sales occurring at a
-articular ti$e o+ the year"
In situations such as these, unerlying trens !ithin the #usiness o-eration
$ay not #e a#le to #e eter$ine #y revie!ing the change in +igures +ro$
one $onth to the ne3t"
=o!ever, the -revious ta#le inclues the -ercentage change in each $onth
+ro$ the sa$e $onth in the -revious year"

These +igures inicate that, on average, the sales in any -articular $onth
!ere 11L higher than the sales o+ the sa$e $onth in the -revious year"
)2)
7ue to the highly volatile sales +igures an the seasonal nature o+ the sales,
this tren $ay not have #een easily ienti+ie +ro$ revie!ing the iniviual
$onthly +igures"
5.2.1.2. -ultiple variables
In so$e situations, t!o se-arate varia#les $ay #e relate"
2or e3a$-le, the a$ount o+ $oney s-ent on avertising $ay have an i$-act
on the sales +igures o+ the #usiness"
In these cases, the relationshi- #et!een the t!o sets o+ nu$#ers can #e
analyse"
5.2.1.2.1. +orrelation
:/orrelation; is a $easure o+ a linear relationshi- #et!een t!o ata sets"
The value o+ the correlation nu$#er $ay vary #et!een <1 an M1"
A correlation o+ @ero suggests that the ata sets $ay #e ine-enent"
In these cases, a value in one ata set $ay not #e a++ecte #y the
corres-oning value in the other ata set"
A correlation o+ M1 inicates that the ata sets are -er+ectly relate, an a rise
or +all in one ata set is $atche #y a -ro-ortional rise or +all in the other
ata set"
A correlation o+ <1 inicates that the ata sets are -er+ectly negatively relate,
!ith a rise in one ata set #eing $atche #y a +all in the other ata set"
/orrelations that are not 0, <1 or M1 inicate that the ata $ay #e -artly
relate, an also -artly ine-enent"
2or e3a$-le, the sales level $ay #e a++ecte #y the avertising #uget, an
$ay also #e a++ecte #y other +actors"
The correlation value can #e calculate using the +or$ula liste in the section
#eginning on -age 1063, or #y using a -ocket calculator or a co$-uter
-rogra$"
)28
2or e3a$-le, the +ollo!ing set o+ ata inclues a list o+ avertising e3-enses
an sales +igures +or a -erio o+ ti$e"
'(vertising #ales
7 1"4.!
13 1"1.3
8 1"1.3
13 1"4.7
14 1"9.5
! 1"2.9
8 1"7.3
15 11".1
8 97.1
8 1"2.3
12 11".7
8 97.7
/orrelation 0"*1
In this e3a$-le, the +igures have a correlation o+ 0"*1"
/orrelation is also e3-resse as a -ercentage, such as *1 L in this case"
The -ositive correlation +igure suggests that high values o+ the avertising
e3-ense $ay #e associate !ith high levels o+ sales"
The accuracy o+ this correlation coul #e esti$ate #y using a con+ience
internal, as escri#e in section #eginning on -age )33"
Also, the $ulti-lication e++ect o+ the avertising e3-ense to the sales increase
coul #e esti$ate #y using a regression, as escri#e in section #eginning
on -age )30"
"
)21
5.2.1.2.1.1. ,*s9uare(
Dhen the correlation is s&uare, this nu$#er is kno!n as the :coe++icient o+
eter$ination;, or $ore si$-ly the :R s&uare;"
This ter$inology is #ase on the co$$on usage o+ the letter :r; to re-resent
correlation in statistics"
This +igure can #e inter-rete at the -ro-ortion o+ one value that is cause #y
the other value"
2or e3a$-le, in the -revious e3a$-le, the +ollo!ing calculation !oul a--ly"
n correlatio n correlatio s!uared r
*1 0 *1 0 . .
30 0.
Assu$ing that the avertising e3-ense cause the sales change an not the
other !ay aroun, this !oul inicate that 30 L o+ the sales +igure !as
relate to the avertising e3-enses, an the re$aining )) L !as relate to
other causes"
5.2.1.2.1.2. 3roperties of orrelation
The correlation value a--lies in #oth irections, an oes not inicate that
one ata set causes a result in the other ata set"
2or e3a$-le, #oth ata sets coul #e a++ecte #y an ine-enent thir +actor,
rather than one ata set causing an e++ect !ithin the other ata set"
/orrelation is ine-enent o+ the average an the stanar eviation"
2or e3a$-le, t!o ata sets coul have a correlation o+ M1, inicating that
they $ove in -er+ect -ro-ortional changes, ho!ever, the ata sets coul
have i++erent average values an i++erent stanar eviations"
)26
Hnless the correlation is M1 or <1, correlation oes not inicate a irect
-ro-ortional $ove"
2or e3a$-le, a correlation o+ 0"* oes not inicate that one ata ite$ $oves
#y one<hal+ o+ the a$ount o+ the other ata ite$"
In these cases, #oth ata sets re$ain rano$ an any values coul occur"
The correlation si$-ly inicates the average value than $ay occur in one
ata set, corres-oning to a -articular value in the other ata set"
/orrelation only inicates a linear, straight<line relationshi- #et!een t!o
ata sets"
T!o ata sets coul #e relate accoring to a non<linear relationshi-, such as
a curve, an yet $ay have a correlation o+ @ero"
5.2.1.2.2. ,egression
5.2.1.2.2.1. 8inear regression
In cases !here one ata set causes the e++ect in the other ata set, an esti$ate
can #e $ae o+ the average result that $ay occur +or the secon ata value"
2or e3a$-le, using the -revious +igures, a -reiction coul #e $ae o+ the
sales that $ay result i+ a -articular level o+ avertising e3-enses !as chosen"
This is kno!n as regression analysis, an $ay involve eter$ining a +or$ula
+or calculating one +igure +ro$ the other +igure"
The +or$ulas +or calculating these values are inclue in the section
#eginning on -age 1063, an are generally inclue !ith statistical +unctions
in calculators an co$-uter -rogra$s"
The ai$ o+ a regression calculation is to eter$ine the values o+ :a; an :#;
in the +ollo!ing e&uation
b firstvalue a ondvalue sec +
)30
Hsing the ata +ro$ the -revious e3a$-le, the +ollo!ing +igures !oul a--ly
A 0"10
B 6*"8
In other ter$s, a linear regression $oel o+ the -revious +igures !oul
-rouce the +ollo!ing +or$ula
8 6* 10 0 . g sin adverti . sales +
This +igure !oul only eter$ine the average level o+ sales ue to
avertising, an #oth the average level o+ sales an the iniviual sales
+igures $ay also #e a++ecte #y other issues"
2or e3a$-le, i+ the avertising #uget !as set to 1*, the average -reicte
sales level coul #e calculate using the +ollo!ing e3a$-le
8 6* 1* 10 0 . . sales +
3 101.
The :A; value can #e inter-rete as the $ulti-lier +actor that a--lies to the
+irst ata value"
In this e3a$-le, the sales level !oul #e relate to 0"10 ti$es the avertising
e3-ense"
In other ter$s, a single ollar o+ avertising e3-ense !oul relate to an 10
cents increase in sales"
This ata !oul suggest that the -articular avertising -rogra$ use !as not
cost e++ective, as sales increase #y a s$aller a$ount than the cost o+ the
avertising"
)31
5.2.1.2.2.2. -ultiple linear regression
Regression can also #e -er+or$e !hen a ata value is relate to t!o or $ore
other ata values"
This is kno!n as $ulti-le linear regression"
A large nu$#er o+ calculations $ay #e involve in eter$ining the
coe++icients in the e&uation, an co$-uter so+t!are !oul nor$ally #e use
to eter$ine these values"
2or e3a$-le, a che$ical -rocess in a -rouction +acility $ay use three ra!
$aterials, !ith the volu$e o+ the che$ical #eing -rouce #eing relate to
the a$ount o+ each ra! $aterial that !as inclue"
This coul #e re-resente in the +ollo!ing e&uation"
d input c input b input a output + + + 3 2 1
The regression -rocess !oul esti$ate the values +or :a;, :#;, :c; an :;"
5.2.1.2.2.3. =on*linear regression
Regression can also #e -er+or$e !hen the relationshi- #et!een the t!o
varia#les is not linear"
In other ter$s, a gra-h o+ the t!o varia#les !oul sho! a curve sha-e rather
than a straight line"
2or e3a$-le, the cost -er unit o+ a $anu+acturing -lant $ay #e relate to the
-rouction ca-acity #y a curve, not a straight line"
In these circu$stances, the ata -oints can #e converte to linear -oints using
the relationshi- #et!een the varia#les, an then the stanar linear regression
+or$ulas coul #e use" (>> check etails)"
)32
5.2.1.2.3. T.e relations.ip bet5een orrelation & regression
The correlation an regression values are linke #y the +ollo!ing +or$ula"
n correlatio
series data first of deviation dard tan s
series data ond sec of deviation dard tan s
a
In this +or$ula, the :a; value is the coe++icient in the regression e&uation that
is $ulti-lie #y the +irst ata value, not the value that is ae to the e&uation
result"
5.2.1.3. Or(ering of (ata sets
Average an stanar eviation +igures are not a++ecte #y the orer o+ the
ite$s !ithin the ata set"
In the case o+ a correlation or regression, the value is not a++ecte #y the
orer o+ the ata set, ho!ever each ata -oint !ithin one ata set $ust
corres-on to a single ata -oint !ithin the other ata set"
5.2.1.4. +onfi(ene intervals
In cases !here the ata $ay re-resent a sa$-le o+ a larger ata set, a +igure,
such as an average, that is calculate +ro$ the sa$-le $ay not $atch the
+igure than a--lies to the +ull set o+ ata"
Sa$-les $ay a--ly !hen a s$all grou- o+ ite$s is use, such as a sa$-le o+
-roucts, or a survey o+ custo$ers"
Also, in the case o+ ata such as a history o+ $arket -rices, the ata $ay
e++ectively re-resent a sa$-le o+ the unerlying e++ects that are causing the
-rice changes"
In these situations, an esti$ate $ay #e $ae o+ the likely range o+ the actual
value !ithin the +ull set o+ ata, #ase on the value that !as calculate +ro$
the sa$-le, the nu$#er o+ ata -oints, an a s-eci+ie -ro#a#ility accuracy
level"
)33
This calculation is kno!n as a con+ience interval"

A con+ience interval can #e calculate #y using the +ollo!ing +or$ula
(>> con+ience internals)
The con+ience interval gives a $ini$u$ an $a3i$u$ range +or a value,
#ase on the si@e o+ the ata sa$-le"
This is #ase on the -ro#a#ility that the true average or other +igure is !ithin
the s-eci+ie range"
2or e3a$-le, the average value o+ a cash +lo! series $ay #e calculate as 80"
Base on a con+ience interval calculation, there $ay #e a 6*L -ro#a#ility
that the actual average o+ the unerlying ata series is !ithin a range such as
)1 to 10"
The con+ience interval #eco$es narro!er as the nu$#er o+ ata -oints
!ithin the calculation is increase, an !ier as the s-eci+ie accuracy o+ the
con+ience level is increase"
2or e3a$-le, a con+ience internal aroun the calculation o+ an average value
!oul #e narro!er !hen 100 ata -oints !ere use to calculate the average,
than !hen 20 ata -oints !ere use"
In contrast, i+ the s-eci+ie accuracy level !as increase +ro$ a -ro#a#ility
level o+ 6*L to a level o+ 66L, the range o+ values !oul #eco$e !ier"
(>> t<tests)
5.2.1.5. #amples
In so$e cases, statistics can #e calculate +ro$ a +ull set o+ values"
2or e3a$-le, in the case o+ -arts that !ere $anu+acture to a s-eci+ie
tolerance, each iniviual -art !oul generally #e !eighe or $easure"
In other cases, a sa$-le o+ ata +ro$ the +ull set o+ in+or$ation $ay #e use"
)30
5.2.1.5.1. #amples
2or e3a$-le, a survey o+ custo$er interest in a -rouct $ay #e conucte, to
asses the likely interest !ithin a !ier range o+ -otential custo$ers"
In the case o+ a $anu+acturing e3a$-le, the crush strength o+ an ite$ can
only #e e++ectively $easure #y -lacing the ite$ in a testing $achine an
$easuring the ite$ strength uner a crush test"
This is kno!n as estructive testing, an in these cases a s$all sa$-le !oul
#e use to esti$ate the -ro-erties o+ the +ull set o+ -roucts"
In other situations, non<estructive testing -roceures can #e use, using
$ethos such as ultrasoun an 3<ray scanning"
In cases !here sa$-le testing is use, a larger sa$-le !oul generally
-rovie a $ore accurate esti$ate o+ the actual value o+ the -ara$eter !ithin
the +ull set o+ -roucts"
A con+ience interval $ay #e calculate #ase on the sa$-le si@e, to esti$ate
the -ro#a#ility that the +igure !ithin the +ull set o+ ite$s !as !ithin a
-articular range aroun the value that !as calculate +ro$ the sa$-le"
5.2.1.5.2. #ample siAes
Dhere -ossi#le, the largest -ractical ata sa$-le shoul generally #e use to
calculate a statistical result"
A +e! o@en +igures $ay -rovie a reasona#le esti$ate o+ an average or a
stanar eviation in a general #usiness analysis, although a large ata
sa$-le !oul allo! a $ore accurate esti$ate to #e calculate"
2or e3a$-le, !eekly -rice returns or sales +igures coul #e use instea o+
$onthly +igures, to allo! a $ore accurate esti$ate o+ volatility to #e $ae"
The use o+ !eekly rather than $onthly +igures !oul not a++ect the average"
5.2.1.5.3. #ample seletion
The selection o+ a sa$-le $ay have a signi+icant i$-act on a calculate
result"
)3*
Statistical analysis generally assu$es that a sa$-le has #een chosen at
rano$ +ro$ the +ull ata set"
The $etho that is use to select a sa$-le $ay result in the sa$-le results
#eing an inaccurate re-resentation o+ the total set o+ ite$s"
2or e3a$-le, i+ the sa$-le -roucts +or a $anu+acturing sa$-le !ere all
selecte +ro$ a single #atch o+ -roucts, or the custo$ers that !ere surveye
!ere selecte in a -articular !ay, then the results o+ the calculations $ay not
re+lect the actual results that $ay a--ly to the +ull set o+ ata"
Sa$-le selection is a $a9or issue in -er+or$ing a statistical analysis"
/alculations the$selves $ay #e reasona#ly straight +or!ar, ho!ever to
ensure an accurate result, in so$e cases a consiera#le a$ount o+ e++ort $ay
#e re&uire to create a sa$-le that $ay #e a rano$ selection +ro$ the +ull
set o+ ata"
2or e3a$-le, i+ a survey o+ custo$ers !as #ase on custo$ers !ho receive
a regular ne!sletter +ro$ the #usiness, this survey $ay only re+lect the vie!s
o+ custo$ers !ho regularly -urchase the #usinessCs -roucts, rather than the
vie!s o+ custo$ers !ho -urchase the ite$s on an iniviual #asis"
5ro#le$s !ith sa$-le selection $ay #e reuce #y using so$e o+ the
+ollo!ing a--roaches"
Hsing rano$ selection, such as a co$-uter -rogra$, rather than
$anually selecting ite$s"
Selecting ite$s +ro$ across the +ull range o+ -roucts rather than
selecting ite$s +ro$ s-eci+ic grou-s"
5er+or$ing calculations +ro$ the +ull set o+ ata, !here this is
-ractical"
In cases !here istinct se-arate su#<grou-s !ithin the +ull ata set
are involve, such as several -roucts, su#<sa$-les $ay #e selecte
+ro$ each grou- in -ro-ortion to the grou- si@e" In so$e cases this
$ay #e against the theory o+ rano$ selection, ho!ever in -ractice
this $ay -rouce a $ore relevant result"
)3)
5.2.2. 3robabilit$
5.2.2.1. +.ane
5ro#a#ility re+ers to the chance o+ +uture events occurring"
Base on -ast history, certain events $ay a--ear to #e $ore likely to occur
than others"
Also, !hen certain actions have #een re-eate $any ti$es, certain -atterns
have e$erge"
Although events cannot #e -reicte, an the +uture is unkno!n, these
-atterns $ay +or$ so$e #asis +or ecisions $ae in the -resent ti$e"
2or e3a$-le, !hen a coin is tosse a very large nu$#er o+ ti$es, the nu$#er
o+ heas an tails tens to average to a level o+ a--ro3i$ately *0L heas an
*0L tails"
=o!ever, the average rarely e&uals e3actly *0L, an large variations in
results can occur"
Asie +ro$ issues relating to +uture events, a :eter$inistic; -rocess is a
-rocess in !hich the out-uts are irectly relate to the in-uts"
2or e3a$-le, the -rocessing rate o+ a $achine $ay #e irectly relate to the
setting that is selecte, !hile the costs o+ a #usiness $ay #e irectly relate to
the -urchase ecisions that are $ae"
A :stochastic; -rocess is a -rocess that incor-orates rano$ ele$ents"
In these cases, the outco$e o+ the -rocess cannot #e irectly -reicte"
2aults generate #y $achine -rocessing are an e3a$-le o+ a stochastic
-rocess"
Also, the nu$#er o+ custo$ers a--earing at a #usiness location !ithin a
-erio o+ ti$e is also a stochastic value"
5.2.2.2. 3robabilit$
The -ro#a#ility that an event $ay occur can #e e3-resse $athe$atically as
a nu$#er #et!een @ero an one"
)38
A -ro#a#ility o+ @ero inicates that the event !ill not occur"
A -ro#a#ility o+ one inicates that the event is certain to occur"
A -ro#a#ility #et!een @ero an one inicates that there is a chance that the
event $ay occur"
2or e3a$-le, a -ro#a#ility o+ 0"* inicates that the event !oul #e e3-ecte
to occur aroun hal+ the ti$e"
This is so$eti$es e3-resse as a -ercentage, in this case #eing *0L"
2or e3a$-le, a stanar ice !ith the nu$#ers 1 through to ) $ay #e thro!n"
The -ro#a#ility o+ the nu$#er 8 occurring !oul #e @ero, !hile the
-ro#a#ility o+ a nu$#er less than 8 occurring !oul #e one"
The -ro#a#ility o+ a t!o a--earing !oul #e one<si3th, or 0"1)8"
5.2.2.3. T$pes of events
5ro#a#ility generally involves certain events occurring"
The !or :event; in this conte3t has a !ie an general $eaning"
2or e3a$-le, the +act that the -rice o+ a ra! $aterial $ay have a certain
value on a certain ay !oul #e an e3a$-le o+ an event, !hich $ay have a
certain -ro#a#ility"
Statistical events $ay +all into t!o categories"
The +irst relates to events that $ay or $ay not occur !ithin a -erio o+ ti$e"
2or e3a$-le, a shortage o+ ra! $aterials $ay or $ay not occur !ithin a
-articular $onth"
This is a ti$e<#ase event"
The secon ty-e o+ event involves a s-eci+ic situation !ere several -ossi#le
outco$es coul occur"
2or e3a$-le, a ice $ay #e thro!n"
)31
In this case, one o+ a range o+ -ossi#le outco$es $ay occur"
The act o+ thro!ing the ice is re+erre to as a :trial;, !hile each o+ the
-ossi#le results is kno!n as an :outco$e;"
The -ro#a#ilities o+ each o+ the -ossi#le outco$es $ust su$ to one, as it is
certain that one o+ the -ossi#le outco$es !ill occur"
In the case o+ the ice, ti$e -erios are not involve, an a thro! o+ a ice is
certain to -rouce one o+ the si3 -ossi#le nu$#ers"
5.2.2.3.1. 4n(ivi(ual events
Iniviual events $ay involve to a s-eci+ic event !hich $ay or $ay not
occur"
2or e3a$-le, a tener $ay #e su#$itte to -er+or$ a -ro9ect evelo-$ent"
The tener !oul either #e acce-te or re9ecte, !ith an announce$ent #eing
$ae at a certain ti$e"
This is an e3a$-le o+ a s-eci+ic event
A single -ro#a#ility a--lies to the chance than the event !ill or !ill not
occur"
5.2.2.3.2. Time*base( events
So$e events coul occur at i++erent -oints in ti$e"
In this conte3t, the length o+ ti$e a++ects the -ro#a#ility that the event $ay
occur"
2or e3a$-le, a #uiling $ay #e insure against +ire"
The -ro#a#ility o+ the #uiling #eing estroye #y +ire at so$e ti$e !ithin
the ne3t +ive years !oul #e greater than the -ro#a#ility o+ the #uiling #eing
estroye #y +ire !ithin the ne3t $onth"
)36
In these cases, the -ro#a#ility o+ the event occurring is relate to the -erio
o+ ti$e that is consiere"
5.2.2.3.3. Time series
So$e ata values change continually as ti$e -asses"
The -rice o+ ite$s sol in $arkets is an e3a$-le o+ this"
In these cases, a nu$#er o+ events coul #e e+ine, each !ith a se-arate
-ro#a#ility"
2or e3a$-le, one event $ay re+er to the chance that a -rice !oul #e #elo! a
certain -oint at so$e ti$e !ithin a ti$e -erio, !hile another event $ay
re+er to the chance that a -rice $ay en a -erio o+ ti$e !ith a value that is
higher than a certain li$it"
Analysis o+ ti$e series is o+ten #ase on the stanar eviation o+ the ata"
This allo!s the -ro#a#ility that a nu$#er !ill #e outsie a -articular range to
#e eter$ine"
5.2.2.4. +alulating probabilit$
5.2.2.4.1. -at.ematial
In the case o+ so$e events, the -ro#a#ility o+ the event occurring can #e
irectly calculate $athe$atically"
()uall*-likel* events
2or e3a$-le, the -ro#a#ility that one o+ a set o+ e&ually<likely events !ill
occur is e&ual to one ivie #y the nu$#er o+ values"
In the case o+ several e&ual events, such as coins an ice, the -ro#a#ility o+
an iniviual value a--earing can #e calculate using the +ollo!ing +or$ula"
)00
items of number
y probabilit
1

2or e3a$-le, in the case o+ a stanar si3<sie ice, the -ro#a#ility o+ a 0

a--earing can #e calculate using the +ollo!ing e3a$-le
)
1
y probabilit
1)8 0.
Distri"utions
In other cases, an assu$-tion is $ae a#out the -attern o+ the ata ite$s"
This is kno!n as a :istri#ution;"
7istri#utions are iscusse in section #eginning on -age )*)"
Assu$ing a certain -attern, the -ro#a#ility that an event !ill occur can #e
calculate"
In -ractice the $ost !iely<use istri#ution is the :nor$al istri#ution;, an
the stanar eviation $ay #e use to calculate the -ro#a#ility that a nu$#er
!ill #e !ithin a certain range"
5.2.2.4.2. 2istorial
In $any cases the -ro#a#ility o+ an event occurring cannot #e irectly
eter$ine"
%sti$ating the -ro#a#ility that an event $ay occur is o+ten #ase on
historical ata"
2or e3a$-le, in the -revious case o+ the #uiling +ire risk, +ire recors $ay
inicate that 0* #uilings !ere estroye #y +ire !ithin an area containing
1*00 #uilings, over a s-eci+ie -erio o+ ti$e"
)01
The ter$ :trial; is so$eti$es use to re+er to a situation !here the event
coul have occurre, an an :event; is an actual occurrence o+ the event"
In these cases, the -ro#a#ility o+ the event occurring can #e calculate using
the +ollo!ing +or$ula
trials of number
events of number
y probabilit
In the e3a$-le o+ the #uiling +ires, this coul #e calculate in the +ollo!ing
!ay"
1*00
0*
y probabilit
03 0.
As another e3a$-le, a trial istri#ution o+ a ne! -rouct $ay involve 1*0
sa$-les #eing istri#ute, !ith a total o+ 30 sales #eing receive"
The -ro#a#ility o+ receiving a sale coul #e calculate using the +ollo!ing
e3a$-le"
trials of number
events of number
sale a of y probabilit
1*0
30

2 0.
)02
5.2.2.4.3. #imulation
In so$e cases, a co$-uter $oel can #e #uil o+ the situation in &uestion"
2or e3a$-le, engineering esign co$$only uses co$-uter si$ulations to
eter$ine the results that !oul occur !hen a -hysical esign !as su#9ect to
various conitions"
Another e3a$-le $ay inclue a #usiness !ith a range o+ i++erent -roucts,
cost structure an $argins"
Si$ulation can #e use to construct a $oel o+ the syste$, generate a large
nu$#er o+ rano$ events, an eter$ine the -ro#a#ility that certain events
$ay occur"
Hsing the -rouct e3a$-le, a range o+ i++erent sales levels coul #e use as
in-uts to the syste$ an use to eter$ine the -ro#a#ility o+ a -ro+it or loss
occurring, assu$ing a certain chance o+ i++erent sales levels"
5.2.2.5. Estimating numbers of events
Dhen the -ro#a#ility o+ an event occurring has #een esti$ate, the average
nu$#er o+ events that $ay #e e3-ecte can #e calculate using the +ollo!ing
+or$ula"
y probabilit trials of number events of number average
2or e3a$-le, in the -revious case o+ the sa$-le -roucts, the sales occurre
!ith a -ro#a#ility o+ 0"2"
I+ a larger istri#ution o+ the -rouct !as launche, !ith a total o+ 2000
-otential sales #eing arrange, then the nu$#er o+ success+ul sales coul #e
esti$ate using the +ollo!ing calculation
y probabilit trials of number events of number average
2 0 2000 .
000
)03
This e3a$-le assu$es that the sa$e conitions a--lie to the original trial
-rouct launch an to the +ull -rouct launch"
Also, this calculation only esti$ates an average +igure that $ay occur"
The actual +igure that occurre in a single situation involving the -rouct
launch $ay #e &uite i++erent +ro$ the average +igure that !as esti$ate"
5.2.2.!. +ombining probabilities
(>> Ine-enent events, anJorJnot events, !ithin the one trialJse-arate
events, coinJice, $utually e3clusive events, conitional events,
scenarios"co$#inations o+ success+ulJunsuccess+ul events")
5.2.2.!.1. C=otD events
The -ro#a#ility that an event !ill not occur is e&ual to one $inus the
-ro#a#ility that it will occur"
This result can #e calculate using the +ollo!ing +or$ula
occuring of y probabilit occuring not of y probabilit 1
2or e3a$-le, the -ro#a#ility o+ thro!ing a * !hen a ice is thro!n is e&ual
to one<si3th, or 0"1)8"
The -ro#a#ility o+ thro!ing a nu$#er that is not a +ive can #e calculate
using the +ollo!ing e3a$-le
1)8 0 1 . y probabilit
133 0.
)00
5.2.2.!.2. C'n(D events
The -ro#a#ility that t!o events !ill #oth occur is e&ual to the iniviual
-ro#a#ilities $ulti-lie together"
This $ay #e is su$$arise in the +ollo!ing +or$ula"
' b ' of y probabilit ' a ' of y probabilit ' b ' and ' a ' both of y probabilit
2or e3a$-le, i+ a coin is tosse an a ice is thro!n, the -ro#a#ility o+ a tail
a--earing is 0"*, !hile the -ro#a#ility o+ the ice sho!ing a 0 is 0"1)8"
The -ro#a#ility that a single thro! o+ a ice an a single toss o+ a coin !ill
-rouce a 0 an a tail can #e calculate using the +ollo!ing e3a$-le"
1)8 0 * 0 . . y probabilit
013* 0.
Dhen several events are involve, each iniviual -ro#a#ility is $ulti-lie
together to eter$ine the -ro#a#ility that all events !ill occur"
2or e3a$-le, in the case o+ events :a;, :#;, :c; an :;, the -ro#a#ility that
all +our events !oul occur coul #e calculate using the +ollo!ing +or$ula"
d c b a y probabilit
5.2.2.!.3. COrD events
/ultiple outcomes within a single trial
In the case o+ a single trial, the -ro#a#ility that either one outco$e or another
outco$e $ay occur can #e eter$ine #y aing the -ro#a#ilities together"
)0*
2or e3a$-le, the +ollo!ing +or$ula coul #e use"
' b ' outcome of y probabilit ' a ' outcome of y probabilit ' b ' or ' a ' outcome of y probabilit +
The -ro#a#ility o+ #oth outco$es occurring is @ero, since each outco$e is
e+ine as a se-arate -ossi#ility, an #oth cannot occur at the sa$e ti$e"
2or e3a$-le, a single thro! o+ a ice cannot -rouce a 3 an also a *"
In the case o+ a ice #eing thro!n, the -ro#a#ility o+ either a 2 or a ) #eing
thro!n coul #e calculate using the +ollo!ing +or$ula"
1)8 0 1)8 0 . . y probabilit +
330 0.
In the case o+ several outco$es, the -ro#a#ility that any one o+ a set o+
outco$es $ay occur is e&ual to the su$ o+ the iniviual -ro#a#ilities"
Separate events
In the case o+ se-arate events, a i++erent situation a--lies"
In this case, the -ro#a#ility that either one event, or the other event, or #oth,
!ill occur can #e calculate #y eter$ining the o--osite value, an
su#tracting it +ro$ one"
This can #e calculate using the +ollo!ing +or$ula
Pro0a0ilit" of CaD or C0D occurring E ( F pro0a0ilit" of CaD not occurring x pro0a0ilirt" of C0D not occurring
This +or$ula coul also #e e3-resse in the +ollo!ing +or$"
Pro0a0ilit" of CaD or C0D occurring E ( F '( A pro0a0ilit" of CaD occurring ) x '( A pro0a0ilirt" of C0D occurring)
)0)
2or e3a$-le, the -ro#a#ility that either a hea !ill #e tosse or a 1 !ill #e
thro!n, or #oth, can #e calculate #y eter$ining the -ro#a#ility that a hea
!ill not #e tosse an that a 1 !ill not #e thro!n"
2or e3a$-le
5ro#a#ility that hea !ill not #e tosse P 1 I 0"*
P 0"*
5ro#a#ility that a 1 !ill not #e thro!n P 1 I 0"1)8
P 0"133
5ro#a#ility that a hea !ill not #e tosse an that a 1 !ill not #e thro!n
P 0"* 3 0"133
P 0"01)*
5ro#a#ility o+ either a hea #eing tosse or a 1 #eing thro!n
P 1 I 0"01)*
P 0"*13*
In $any -ro#a#ility calculations, a si$-ler calculation can #e -er+or$e #y
calculating the -ro#a#ility o+ the o--osite result occurring"
The -ro#a#ility o+ the original result can then #e eter$ine #y su#tracting
the +igure +ro$ one"
5.2.2.!.4. CE)lusive OrD events
An e3clusive<or event occurs !hen either one event occurs, or the other event
occurs, #ut not #oth"
)08
The -ro#a#ility o+ this occurring can #e calculate using the +ollo!ing
+or$ula"
Pro0a0ilit" of either CaD or C0D occurring 0ut not 0oth E
Pro0a0ilit" of CaD @ pro0a0ilit" of C0D F % x pro0a0ilit" of CaD x pro0a0ilit" of C0D
2or e3a$-le, the -ro#a#ility that a hea !ill #e tosse, or that a 1 !ill #e
thro!n, #ut not #oth, can #e calculate using the +ollo!ing a--roach"

5ro#a#ility P 0"* M 0"1)8 I 2 3 0"* 3 0"1)8
P 0"*
5.2.2.7. T.e value of unertain as. flo5s
5.2.2.7.1. #ingle events
In so$e situations, a +uture cash +lo! $ay or $ay not occur"
2or e3a$-le, -ay$ents ue +ro$ custo$ers $ay or $ay not #e receive"
In the case o+ the #uiling e3a$-le, a +ire in the #uiling $ay re&uire a
-ay$ent to construct a ne! #uiling"
In these situations, the e++ective value o+ the cash +lo! can #e eter$ine
+ro$ the si@e o+ the cash +lo!, an the -ro#a#ility o+ it occurring"
In these cases, the e++ective value o+ the cash +lo! can #e calculate using the
+ollo!ing +or$ula
y probabilit amount value effective
This e&uation s-eci+ies a +una$ental relationshi- #et!een e++ective values
an -ro#a#ilities"
)01
This issue $ay arise in $any areas o+ #usiness an +inance, incluing areas
such as valuing -ro9ects, calculating insurance -re$iu$s, an -lanning
activities such as -rouct launches"
I+ the cash +lo! $ay occur at a ate in the istant +uture, then the -resent
value $ay also nee to #e calculate using a -resent value calculation, as
escri#e in the section #eginning on -age 820"
2or e3a$-le, a ne! -rouct $ay #e launche, !ith an esti$ate 10L chance
o+ success"
The value o+ the ne! -rouct, i+ success+ul, $ay #e G*0"
In this case, the value o+ the -rouct #e+ore the launch coul #e calculate
using the +ollo!ing e3a$-le
1 0 *0 . value
00
I+ the -rouct !as to #e sol -rior to launch, then the value o+ the -rouct
!oul #e G00"
A+ter the launch !as co$-lete, the value !oul #e either G0 or G*0"
This a--roach $ay ena#le a value to #e -lace on uncertain +uture events,
#e+ore they occur"
'aluing +uture events $ay #e use +or so$e o+ the +ollo!ing -ur-oses"
/alculating asset values as -art o+ -re-aring a #alance sheet"
7eter$ining the -otential -ro+it or loss #e+ore $aking a ecision as
to !hether to -rocee !ith a -ro9ect"
%sti$ating a sale -rice +or the sale or -urchase o+ a -ro9ect or a
transaction"
7eter$ining the risk an -otential losses that the #usiness $ay #e
e3-ose to"
)06
As another e3a$-le, a #uiling !ith a value o+ G100 $ay have a -ro#a#ility
o+ 0"02 o+ #eing estroye #y +ire !ithin a 1<year -erio"
The e++ective value o+ this -otential cash +lo! coul #e calculate using the
+ollo!ing a--roach
02 0 100 . value
2
This a--roach $ay #e use to calculate an insurance -re$iu$ +or a +ire
insurance -olicy"
This is also kno!n as the :-rice o+ risk;"
5.2.2.7.2. 7nertain values
In so$e cases, a cash +lo! or value $ay #e e3-ecte to occur, ho!ever the
si@e o+ the cash +lo! $ay #e unkno!n"
This $ay a--ly to values such as +uture sales inco$e, +uture $aterials costs
an so on"
In these cases, the e++ective value o+ the cash +lo! is e&ual to the average o+
the -ossi#le values"
The average value can #e calculate +ro$ the average value o+ a ata series"
Alternatively, the average value $ay #e eter$ine +ro$ the !eighte
average value o+ a set o+ -ossi#le outco$es, !ith each value !eighte
accoring to the -ro#a#ility o+ it occurring"
2or e3a$-le, $onthly cash +lo! $ay have an average value o+ G160 an a
stanar eviation o+ G2*"
In this case, the e++ective value o+ the ne3t $onthCs cash +lo! !oul #e G160"
The stanar eviation o+ the values is a se-arate issue"
)*0
Mathe$atically the e++ective value o+ an uncertain cash +lo! is not relate to
the stanar eviation"
=o!ever, a lo! value $ay #e -lace on #usinesses or -ro9ects that involve
volatile or highly uncertain cash +lo!s"
5.2.2.7.3. #enarios
The value o+ a cash +lo! or asset value e-ens on the -ossi#le values that
$ay occur, an the -ro#a#ility o+ each value occurring"
This a--lies in all cases, !hether the value has a continuous range o+ -ossi#le
values, o+ !hether it has a iscrete set o+ -ossi#le values"
2or e3a$-le, the value o+ an asset $ay have a continuous range o+ -ossi#le
values, !hile a cash +lo! ue to an insurance -olicy has only t!o -ossi#le
values, either @ero, or the +ull value o+ the #uiling"
The e++ective value o+ an event can calculate as the !eighte average o+ the
-ossi#le values, !ith the -ro#a#ilities o+ each outco$e #eing use as the
!eights"
This $ay involve $ulti-lying the -ro#a#ility #y the value +or each outco$e,
an aing the results together"
This calculation coul #e su$$arise in the +ollo!ing +or$ula"
outcome possible each for ' y probabilit value ' of sum value
2or e3a$-le, in the case o+ a #uiling insurance, the +ollo!ing -ossi#le
outco$es $ay occur
Autco$e /ash 2lo! 5ro#a#ility
2ire 100 0"02
4o 2ire 0 0"61
)*1
The value o+ this cash +lo! coul then #e calculate using the +ollo!ing
a--roach
outcome possible each for ' y probabilit value ' of sum value
61 0 0 02 0 100 . . +
2 5
The calculation $ay #e $ore i++icult in the case o+ a continuous range o+
-ossi#le outco$es, such as the $arket -rice o+ a ra! $aterial"
In so$e cases, an analytical e&uation can #e use +or this situation"
In other cases, the range o+ -ossi#le values coul #e ivie into a nu$#er o+
se-arate #ans, such as 100 se-arate su#<ranges, an a si$ilar calculation to
the -revious +or$ula coul #e use #ase on the iniviual su#<ranges"
Ather e3a$-les o+ valuing uncertain values $ay inclue an esti$ate o+ the
value o+ a ne! -rouct launch"
This $ay #e one #y e+ining a set o+ scenarios, together !ith the value in
each case, an an esti$ate o+ the -ro#a#ility o+ each outco$e"
Scenario analysis $ay #e use to value -ro9ects an activities such as -rouct
launches"
2or e3a$-le, the +ollo!ing esti$ates $ay #e $ae +or a -rouct launch
'alue 5ro#a#ility
'ery +avoura#le res-onse 10 10L
Success+ul launch )0 30L
Reasona#ly success+ul launch *0 30L
5oor res-onse 20 20L
'ery lo! res-onse <10 10L
)*2
The value o+ this -ro9ect coul then #e calculate using the +ollo!ing
a--roach"
outcome possible each for ' y probabilit value ' of sum value
100
10
10
100
20
20
100
30
*0
100
30
)0
100
10
10 + + +
00 5
The -ro#a#ility +igures $ay #e #ase on the esti$ates o+ the likely outco$es,
rather than $athe$atical calculations"
The -rocess o+ evelo-ing scenarios an -er+or$ing the calculations $ay #e
use+ul in evelo-ing a clearer -icture o+ the -ossi#le outco$es an the value
o+ the -ro9ect

5.2.2.8. ,an(om variables
A :rano$ varia#le; is a statistical conce-t that involves a ata ite$ that has
rano$ values +ro$ one -oint to another"
%3a$-les o+ rano$ varia#les in #usiness situations $ay inclue the
$onthly cash +lo!s, an the change in the $arket -rice o+ volatile
co$$oities"
Characteristics of random varia"les
A rano$ varia#le $ay have an average value, a stanar eviation, an a
-ro#a#ility istri#ution"
The istri#ution s-eci+ies the -ro#a#ility o+ various i++erent values
occurring"
A rano$ varia#le has an i$-ortant -ro-erty, in that the value o+ the varia#le
cannot #e -reicte +ro$ the -revious values"
)*3
2or e3a$-le, the $onthly cash +lo! +or a #usiness o-eration $ay #e an
e3a$-le o+ a rano$ varia#le"
Monthly cash +lo!s $ay have an average value, an a stanar eviation"
The value o+ the ne3t $onthly cash +lo! $ay not #e a#le to #e -reicte
+ro$ the values o+ -revious cash +lo!s, asie +ro$ eter$ining an average
value"
#on-predicta"ilit*
The non<-reicta#ility o+ a rano$ varia#le can #e illustrate using an
e3a$-le o+ tossing a coin"
In the case that a long series o+ tails a--eare, this !oul not inicate that
there !as an increase chance o+ a hea a--earing on the ne3t toss o+ the
coin"
Also, it !oul not inicate that a long series o+ heas coul #e e3-ecte, in
orer to #alance the series o+ tails that ha a--eare"
In all cases, the chance o+ a hea or a tail re$ains *0L on the ne3t toss o+ the
coin, an +uture coin tosses are not a++ecte #y tosses o+ the coin that
occurre in the -ast"
Another -ers-ective o+ this situation is that a coin is si$-ly a isk $ae o+
$etal"
A coin oes not have a $e$ory"
It oes not kno! !hether it has #een tosse in the -ast or not, an +uture
events are #ase on the structure o+ the coin, rather than -revious tosses o+
the coin"
Although this e++ect $ay #e against natural intuition, this issue is
+una$ental to rano$ ata an to issues o+ risk !ithin #usiness"
2or e3a$-le, !hen a $arket -rice +alls or rises signi+icantly, there is no
reason to suggest that the -rice !ill reverse its -revious $ove, to return to the
original level"
Both in theory an in -ractice, the ne! value o+ the -rice sets the #ase level
+or any +uture -ositive or negative $oves, an -revious -rices #eco$e
largely irrelevant in esti$ating +uture -rices"
)*0
This issue is relate to the +act that a ecision to sell an asset shoul not
inclue issues relating to the -urchase -rice or !hether the transaction !ill
generate a -ro+it or a loss, #ut shoul instea consier only the +uture
-ossi#le outco$es"
2or e3a$-le, i+ the -rice o+ an asset has +allen since the asset !as -urchase,
a loss has alreay occurre, an this cannot #e reverse #y avoiing selling
the asset at the current -rice"
Although the asset -rice $ay rise, there $ay #e no -articular reason to
suggest that a rise in the -rice o+ a -articular asset is any $ore likely than an
increase in the -rice o+ another asset than coul #e -urchase !ith the +uns
that coul #e raise +ro$ selling the asset"
Correlation
Although the value o+ a rano$ varia#le is not relate to -revious values o+
the sa$e varia#le, it $ay #e relate to other varia#les"
This e++ect $ay #e $easure using the correlation an regression a--roaches"
2or e3a$-le, the value o+ t!o rano$ varia#les $ay #e co$#ine into a
thir value"
In the case o+ all three ata sets, the values coul not #e -reicte +ro$
-revious values"
=o!ever, the value a ata ite$ in the thir ata set $ay #e -artly relate to
the value o+ the corres-oning ite$ in either the +irst or the secon ata set"
5.2.2.9. Data series & ran(om 5al6s
In the case o+ a ata series such as $onthly cash +lo!s, the average value
$ay #e a constant +igure"
In this case, a +i3e average +igure $ay a--ly to the ata values, an a
stanar eviation $ay re+er to the stanar eviation o+ the ata values"
Market -rices o+ten a--ear to o-erate on a #asis kno!n as a :rano$ !alk;"
)**
In the case o+ a rano$ !alk, the average value o+ a ata value is #ase on
the -revious ata value, rather than a constant value"
In this situation, the -ercentage changes, rather than the -rices the$selves,
$ay +or$ a rano$ varia#le !ith a sta#le average an stanar eviation"
5.2.2.1".3robabilit$ Distributions
A -ro#a#ility istri#ution s-eci+ies the -ro#a#ility o+ each -ossi#le outco$e
occurring"
5ro#a#ility istri#utions $ay #e iscrete, !here there $ay #e a s-eci+ic list
o+ -ossi#le outco$es, or continuous, !here a ata value $ay have an
unli$ite set o+ -ossi#le values, #ut !ith i++erent -ro#a#ilities o+ values
occurring in i++erent ranges"
2or e3a$-le, the thro! o+ a ice has si3 -ossi#le outco$es, !hile the -rice
o+ oil has a continuous set o+ -ossi#le values"
5.2.2.1".1. 8inear
A linear istri#ution occurs !hen each outco$e has an e&ual -ro#a#ility o+
occurring"
/oins an ice are e3a$-les o+ this"
,inear istri#utions can #e iscrete or continuous"
In the case o+ a iscrete istri#ution, the -ro#a#ility o+ a -articular outco$e
occurring can #e calculate using the +ollo!ing +or$ula"
outcomes possible of number
y probabilit
1

In the case o+ a continuous linear istri#ution, the -ro#a#ility that a nu$#er

$ay occur !ithin a -articular range o+ values can #e calculate using the
+ollo!ing +or$ula"
)*)
value possible imum min value possible imum max
value range imum min value range imum max
y probabilit

Rano$ nu$#ers that are generate #y co$-uter -rogra$s an calculators

o+ten have a continuous linear istri#ution"
5.2.2.1".2. =ormal
A -articular -ro#a#ility istri#ution is kno!n as the :nor$al istri#ution;"
Dhen a large nu$#er o+ se-arate e++ects are co$#ine together, the net result
#eco$es close to the nor$al istri#ution, regarless o+ the istri#ution o+ the
unerlying e++ects (>> check etails)"
2or e3a$-le, although a ice has a linear istri#ution, i+ a ice is thro!n
$any ti$es, then the total a$ount +ro$ all the ice thro!s !ill have an
a--ro3i$ately nor$al istri#ution -attern"
The nor$al istri#ution has the +ollo!ing a--earance !hen -resente as a
gra-h"
)*8
Normal 3robability Distribution
".""
"."5
".1"
".15
".2"
".25
".3"
".35
".4"
".45
*5." *4." *3." *2." *1." "." 1." 2." 3." 4." 5."
Stan(ar( Deviations
3
r
o
b
a
b
i
l
i
t
y
2igure 8
The height o+ a -oint on the gra-h inicates the -ro#a#ility that a value o+
that si@e $ay occur"
This inicates that the values close to the average have a high -ro#a#ility o+
occurring, !hile values +ar +ro$ the average have a very lo! -ro#a#ility o+
occurring"
2or e3a$-le, the -ro#a#ility o+ a nu$#er occurring #et!een 1 an 1"2
stanar eviations a#ove the average coul #e calculate +ro$ the area o+
the gra-h, !hich !oul #e relate to the height o+ the curve aroun the 1"0
stanar eviation -oint"
The -ro#a#ility o+ a ata value occurring that is $ore than one stanar
eviation a#ove the average is 1)L, !hile the -ro#a#ility o+ a value
occurring that is $ore than t!o stanar eviations a#ove the average is
2"3L"
4or$al istri#utions occur in $any conte3ts, ranging +ro$ the istri#ution o+
!eights o+ $anu+acture ite$s, to the -ercentage $oves in $arket -rices"
)*1
The assu$-tion o+ a nor$al istri#ution allo!s the -ro#a#ility o+ certain
value ranges occurring to #e calculate"
5.2.2.1".3. 2istorial (istributions
In so$e cases, historical ata can #e use to esti$ate the istri#ution -attern
o+ a rano$ varia#le"
2or e3a$-le, although the -rice o+ trae ite$s o+ten +ollo!s a nor$al
istri#ution, this $ay so$eti$es #e a :+at taile; or :le-tokurtic;
istri#ution"
This $eans that the istri#ution sha-e is a--ro3i$ately e&ual to the nor$al
istri#ution, ho!ever the ens o+ the istri#ution are larger than a nor$al
istri#ution, an the -ro#a#ility o+ e3tre$e high values or e3tre$e lo!
values occurring is higher than it !oul #e i+ a nor$al istri#ution !as in
-lace"
In situations such as these, historical ata can #e use to esti$ate the sha-e o+
a istri#ution, to allo! a $ore accurate esti$ate o+ -ro#a#ility to #e $ae"
5.2.2.11. 3robabilit$ of ranges
Dhen a -ro#a#ility istri#ution is kno!n or an assu$-tion is $ae, the
-ro#a#ility o+ nu$#ers occurring !ithin certain ranges can #e calculate"
2or e3a$-le, the +ollo!ing ta#le -resents so$e +igures that a--ly to a nor$al
istri#ution"
These +igures s-eci+y the -ro#a#ility that a nu$#er !ill #e $ore than the
s-eci+ie istance a!ay +ro$ the average"
#tan(ar(
Deviations
3robabilit$ of a
lo5 figure
3robabilit$ of a
.ig. figure
3robabilit$ of
a .ig. or lo5
figure
"."" 5"." < 5"." < 1""." <
)*6
".25 4".1 < 4".1 < 8".3 <
".5" 3".9 < 3".9 < !1.7 <
".75 22.7 < 22.7 < 45.3 <
1."" 15.9 < 15.9 < 31.7 <
1.25 1".! < 1".! < 21.1 <
1.5" !.7 < !.7 < 13.4 <
1.75 4." < 4." < 8." <
2."" 2.3 < 2.3 < 4.! <
2.25 1.2 < 1.2 < 2.4 <
2.5" ".! < ".! < 1.2 <
2.75 ".3 < ".3 < ".! <
3."" ".1 < ".1 < ".3 <
2igure 1
2or e3a$-le, #ase on this ta#le, the -ro#a#ility that a nu$#er !oul #e
larger than 1"2* stanar eviations a#ove the average !oul #e 10") L"
The -ro#a#ility is #ase on the nu$#er o+ stanar eviations that the ata
-oint is a!ay +ro$ the average"
This can #e calculate using the +ollo!ing +or$ula
deviation dard tan s
change the of si6e
deviations dard tan s of number
In the case o+ a ata series !ith a +i3e average, such as a set o+ cash +lo!s or
custo$er nu$#ers, the +ollo!ing calculation can #e use to eter$ine the
si@e o+ the change
average value ne( change the of si6e
In the case o+ a ata value that is less than the average, this +or$ula !ill
-rouce a negative result"
))0
=o!ever, only the si@e o+ the value itsel+, rather than the negative or -ositive
sign, shoul #e use to calculate the nu$#er o+ stanar eviations o+ a
change"
In this situation, the stanar eviation $ay #e calculate irectly +ro$ the
ata values"
In the case o+ ata -oints +ollo!ing a rano$ !alk -attern, such as $arket
-rices, the +ollo!ing calculation $ay #e use
value old
value old value ne(
change of si6e

In this case, the stanar eviation $ay #e calculate as the stanar

eviation o+ the -ercentage changes +ro$ one ata -oint to the ne3t, rather
than #eing calculate irectly +ro$ the ata values"
2or e3a$-le, the +ollo!ing t!o ata series $ay a--ly to a set o+ cash +lo!s
an $arket -rices"
+as. -ar6et 3rie
/lo5s 3ries +.ange
994 95"
882 819 *14<
959 9"! 11<
1""9 1"28 13<
998 9"2 *12<
949 788 *13<
93" !7! *14<
1"34 8"7 19<
1"34 739 *8<
1"58 882 19<
9"3 777 *12<
1"49 758 *3<
995 7!2 1<
9"9 774 2<
981 813 5<
9!4 884 9<
1"!4 997 13<
9!" 877 *12<
114" 817 *7<
1"34 85" 4<
1122 955 12<
))1
853 858 *1"<
1"41 91! 7<
884 829 *1"<
931 9"" 9<
1"!! 88" *2<
1"32 989 12<
1"1" 1"84 1"<
1"92 1"87 "<
1"1" 12"9 11<
1""7 1328 1"<
871 1348 2<
97! 1288 *4<
947 1435 11<
87" 14!8 2<
929 1352 *8<
#tan(ar( 73 1"<
Deviation
The +ollo!ing chart illustrates the i++erent -atterns that $ay occur in the t!o
ty-es o+ ata series"
In the case o+ the +i3e average, each ata -oint is a rano$ value aroun a
+i3e average -oint"
In the case o+ the rano$ !alk, each ata -oint is a rano$ value aroun the
-revious value"
))2
5i8e( average & *an(om %al+ (ata
"
2""
4""
!""
8""
1"""
12""
14""
1!""
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
/i)e( average
,an(om 5al6
2igure 6
))3
The -rice o+ a volatile ra! $aterial $ay have a current -rice o+ G100 an a
stanar eviation o+ -rice changes o+ 1L -er $onth"
Market -rices are assu$e to +ollo! a rano$ !alk -attern, so the current
-rice is use as the re+erence -oint, an !oul #e use as the average value
in this calculation"
A -ro#a#ility that the -rice !ill rise a#ove G110 at the en o+ the ne3t $onth
coul #e calculate using the +ollo!ing e3a$-le"
value old
value old value ne(
change of si6e

100
100 110

1 0.
10
deviation dard tan s
change the of si6e
deviations dard tan s of number

1
10

2* 1.
This inicates that the li$it -rice is 1"2* stanar eviations a#ove the
current -rice"
Re+erring to the ta#le in 2igure 1 on -age ))0, this suggests that there is an
a--ro3i$ately 10")L chance that the -rice o+ the ra! $aterial !oul rise
a#ove G110 #y the en o+ the ne3t $onth"
))0
Taking the o--osite a--roach, the -ro#a#ility $ay #e selecte, an a value
$ay #e eter$ine #ase on a -ro#a#ility"
In the case o+ a +i3e average, the +ollo!ing +or$ulas $ay #e use to
esti$ate a ata -oint"
deviation dard tan s deviations d tan s of number average value upper +
deviation dard tan s deviations d tan s of number average value lo(er
In the case o+ a rano$ !alk, !here the stanar eviation re+ers to
-ercentage changes, the +ollo!ing +or$ulas $ay #e use"
deviation dard tan s deviations d tan s of number 7 value current value upper + 1
deviation dard tan s deviations d tan s of number 7 value current value lo(er 1
As an e3a$-le, a 1L -ro#a#ility level $ay #e selecte to esti$ate the -rice
change that $ay occur +or a $arket -rice in an e3tre$e -rice $ove"
Re+erring to the -revious ta#le, this -ro#a#ility corres-ons to a ata -oint o+
a--ro3i$ately 2"2 stanar eviations"
Assu$ing a current value o+ G6* an a stanar eviation o+ *L -er $onth,
the -rice that $ay occur in 1L o+ $onths coul #e esti$ate using the
+ollo!ing e3a$-le"
( ) 0* 0 2 2 1 6* . . value upper +
10* 5
( ) 0* 0 2 2 1 6* . . value lo(er
1* 5
))*
This e3a$-le illustrates that an e3tre$e -rice $ove, !hich $ay occur in 1L
o+ cases, $ay result in the $arket -rice o+ G6* rising to G10* or +alling to
G1*"
/alculations #ase on the nor$al istri#ution can #e -er+or$e using
co$-uter so+t!are such as s-reasheet -rogra$s"
5.2.2.12.:olatilit$
5.2.2.12.1. Time series volatilit$
In cases such as cash +lo!s, the stanar eviation o+ the actual nu$#ers
coul #e use to eter$ine the volatility o+ the varia#le"
This a--roach can #e taken in any case !here the average value is e3-ecte
to #e constant through the ata set"
In the case o+ $arket -rices, the stanar eviation o+ the -ercentage changes
is nor$ally use, rather than the stanar eviation o+ the actual -rices"
Dhile the -ercentage changes o+ a $arket -rice $ay #e rano$ly istri#ute,
the -rice itsel+ $ay ri+t higher or lo!er, rather than re$aining centre
aroun a sta#le level"
2or e3a$-le, the +ollo!ing ata sho!s a set o+ $onthly -rices +or a 12<
$onth -erio"
3rie +.ange
1""
93 *7<
98 5<
1"1 3<
1"8 7<
1"! *2<
1"9 3<
91 *17<
1"2 13<
95 *7<
)))
stan(ar( 9<
(eviation
The stanar eviation o+ the -ercentage changes in this e3a$-le i+ 6L"
This stanar eviation coul #e a--lie to the -revious ta#le o+
-ro#a#ilities, to eter$ine the chance o+ a certain -ercentage $ove +ro$ the
current -rice"
2or e3a$-le, a -ercentage $ove o+ 11L !oul re-resents 2 stanar
eviations co$-are to the stanar eviation o+ 6L"
Base on the ta#le in 2igure 1 on -age ))0, there !oul #e a 2"3L chance o+
the -rice rising #y $ore than 11L over the co$ing $onth, an a 2"3L
chance o+ the -rice +alling #y $ore than 11L"
5.2.2.12.2. :olatilit$ over time
The volatility o+ a ti$e series over long or short ti$e -erios can #e
calculate using the +ollo!ing +or$ula"
periods of number period per deviation dard tan s deviation dard tan s
2or e3a$-le, in the -revious e3a$-le, the stanar eviation o+ the $onthly
returns !as 6L"
This coul #e converte into a stanar eviation o+ annual returns using the
+ollo!ing e3a$-le"
12 6 deviation dard tan s
0) 3 6 .
31
))8
In this e3a$-le, the volatility o+ the $onthly returns !oul #e 6L, an the
volatility o+ the annual returns !oul #e 31L"
The chance o+ a certain -ercentage change over a year coul #e calculate
using the -revious e3a$-les, using the rate o+ 31L as the stanar eviation"
This is less than 12 ti$es the $onthly volatility, as iniviual $onths $ay
rise or +all, an $ay -artly cancel each other out"
5.2.2.12.3. :olatilit$ over multiple events
5.2.3. Time*base( events
In the case o+ ti$e<#ase events, such as the chance o+ an event occurring
!ithin a certain -erio o+ ti$e, the -ro#a#ility o+ the event occurring is
relate to a s-eci+ic -erio o+ ti$e"
2or e3a$-le, the -ro#a#ility o+ a #uiling #eing estroye #y +ire $ay #e 2L
in any 1<year -erio"
The -ro#a#ility o+ the #uiling #eing #urne !ithin a 2 year -erio is not 0L"
The -ossi#ility o+ a +ire in either the +irst or secon years are ine-enent
events, an the -ro#a#ility o+ either event ha--ening cannot #e eter$ine #e
si$-ly aing the -ro#a#ilities (>>etails)

In the case o+ ti$e<#ase events, the -ro#a#ility o+ an event occurring !ithin
$ulti-le -erios o+ ti$e can #e eter$ine #y calculating the o--osite event"
In other !ors, this can #e eter$ine #y calculating the -ro#a#ility that the
#uiling !ill not #e #urne in either the +irst year, an also that it !ill not #e
#urne in the secon year, an su#tracting this -ro#a#ility +ro$ one"

This leas to the +ollo!ing +or$ula +or ti$e<#ase -ro#a#ilities"
( )
periods of number
y probabilit 8 period 8 gle sin y probabilit 1 1
))1
2or e3a$-le, the -ro#a#ility o+ the #uiling #eing estroye #y +ire !ithin
the ne3t +ive years can #e calculate using the +ollo!ing e3a$-le"
( )
*
02 0 1 1 . y probabilit
.) 6
This can #e illustrate in the +ollo!ing chart, !hich is-lays the -ro#a#ility
o+ the #uiling #eing #urne !ithin the s-eci+ie ti$e -erio"
3robability of an event occuring
"<
1"<
2"<
3"<
4"<
5"<
!"<
7"<
8"<
9"<
1""<
" 2" 4" !" 8" 1"" 12" 14" 1!"
'ength of time
3
r
o
b
a
b
i
l
i
t
y
2igure 10
))6
5.2.4. 3ortfolios
In so$e #usiness situations, several events are co$#ine into a single set o+
values"
In these cases, the stanar eviation o+ the total a$ount $ay #e less than the
stanar eviation o+ the iniviual ite$s"
This occurs #ecause the iniviual ite$s $ay rise an +all at i++erent ti$es,
!hich $ay -artially cancel the net change, an lea to a less volatile value
+or the total a$ount"
In the case o+ events that $ay or $any not occur, !hen a large nu$#er o+
risks are co$#ine into a single -ort+olio, the chance o+ every single event
occurring $ay #e very lo!"
This e++ect is kno!n as :iversi+ication;, an is a $a9or $etho o+ reucing
risks in #usiness an invest$ent situations"
2or e3a$-le, this a--roach is use in invest$ent $anage$ent #y co$#ining
several invest$ents into a single -ort+olio, an this a--roach is also the #asis
o+ insurance, !here a large nu$#er o+ -olicies are co$#ine into a single
-ool o+ +uns"
As an e3a$-le o+ this e++ect, the +ollo!ing gra-h sho!s the reuction in
volatility that $ay occur !hen a single a$ount is s-lit into several
ine-enent s$aller a$ounts"
This e3a$-le is #ase on ine-enent events, !here each event has an e&ual
volatility, an the ite$s are also e&ually !eighte !ithin the total"
)80
1olatility of a portfolio
"<
1"<
2"<
3"<
4"<
5"<
!"<
7"<
8"<
9"<
1""<
" 5 1" 15 2" 25 3" 35 4" 45 5"
Number of items
1
o
l
a
t
i
l
i
t
y

o
r

r
i
s
+
2igure 11
This e3a$-le assu$es the +ollo!ing conitions +or each risk !ithin the
-ort+olio"
The risks are ine-enent, so that the correlation #et!een any t!o
risks is @ero"
%ach risk has the sa$e volatility as the other risks"
%ach risk has the sa$e !eight !ithin the -ort+olio"
As an e3a$-le o+ iversi+ication, !hen these three conitions are $et, the
-ort+olio volatility can #e calculate using the +ollo!ing +or$ula"
)81
ris$s of number
ris$ individual an of devaiation dard tan s
deviation dard tan s
In cases !here the events are ine-enent, the correlation !ill #et!een each
event $ay #e @ero, an the volatility o+ the total +alls to!ar @ero !hen the
nu$#er o+ iniviual ite$s is large"
Dhen the ite$s have a high correlation an $ove in a si$ilar -attern, there
$ay #e little iversi+ication e++ect, an the volatility o+ the total a$ount $ay
only reuce slightly"
The stanar eviation o+ a -ort+olio o+ ite$s can #e calculate using a
+or$ula in the section #eginning on -age 1063"
5.2.5. #tatistial estimation
A nu$#er o+ -ractical issues $ay arise !ith a--lying statistical analysis to a
set o+ +igures"
In so$e cases, although a +igure can #e $athe$atically calculate, the
accuracy or -ractical relevance o+ the +igure $ay #e li$ite"
2or e3a$-le, although a stanar eviation coul #e calculate +ro$ three
annual +igures, the +act that only three +igures !ere inclue in the sa$-le
$ay result in the actual nu$#er having li$ite use in +orecasting +uture
values"
5.2.5.1. #tationar$ series
5ro#le$s $ay arise !hen the unerlying causes that -rouce a set o+
nu$#ers changes over ti$e"
2or e3a$-le, i+ the structure or o-eration o+ a #usiness changes over ti$e,
then any +igures that relate to -revious -erios $ay not #e relevant to
calculating -ro#a#ilities o+ +uture events occurring"
)82
In the case o+ ata such as $arket -rices, i+ the unerlying volatility changes
signi+icantly uring the -erio o+ the sa$-le, then a volatility calculation
over the +ull -erio $ay not -rouce a use+ul esti$ate o+ the likely +uture
volatility"
5.2.5.2. Outliers
An :outlier; is a ata value that is $uch higher or $uch lo!er than the rest
o+ the ata sa$-le"
This $ay #e ue to an error such as a ty-ing $istake, or it $ay si$-ly #e an
unusual value that occurre -urely #y chance"
Autliers $ay cause a large change in +igures such as averages an stanar
eviations"
Stanar eviation $ay #e -articularly a++ecte #y outliers, as the calculation
is #ase on the iniviual i++erences #eing s&uare"
A single unusual value !ithin several hunre ata -oints can result in a
noticea#le i++erence in a stanar eviation +igure"
It is co$$on !ithin statistical analysis to re$ove outliers +ro$ the ata
sa$-le #e+ore calculating statistical results"
This $ay ena#le a $ore accurate re+lection o+ the unerlying e++ects to #e
eter$ine, an this a--roach $ay #e -articularly use+ul !ith the results are
use +or $oelling transactions such as -ro9ect cash +lo!s, an !hen the
results are use +or +orecasting"
=o!ever, this !oul not generally a--ly in the case that the +igures !ere
calculate +or the -ur-ose o+ re-orting actual results, rather than +or
$oelling or +orecasting -ur-oses"
5.2.5.3. #purious orrelations
/orrelation +igures $ay so$eti$es suggest that a relationshi- e3ists #et!een
t!o sets o+ nu$#ers, !hen in +act this is not the case"
/orrelations can arise !hen they o not e3ist !ithin the unerlying cause o+
the ata in so$e o+ the +ollo!ing circu$stances"
)83
Ine-enent thir +actors Both ata series $ay #e relate to a thir +actor,
even through there $ay #e no cause<an<e++ect
relationshi- #et!een the t!o ata series" 2or
e3a$-le, the sales +igures o+ sun tan crea$ an
sun hats $ay #e correlate, even though one ata
series i not cause the other"
Rano$ chance A correlation $ay a--ear #et!een t!o sets o+
rano$ nu$#ers #y -ure chance"
/hoice o+ sa$-le The choice o+ !hich ata to inclue in the sa$-le,
an ho! the ata shoul #e e+ine, $ay create a
correlation !hen in +act no correlation actually
e3ists !ithin the unerlying syste$"
7irectional e++ects Dhere a correlation e3ists #et!een t!o sets o+
nu$#ers an a cause<an<e++ect relationshi- is the
cause o+ the correlation, the correlation oes not
s-eci+y !hich ata set is the cause an !hich ata
set is the result" This can only #e eter$ine #y
$aking an assu$-tion as to !hich ata set is
causing the other ata set, an in so$e cases an
a--arently o#vious link $ay in +act #e occurring
in reverse"
5.2.5.4. 'ltering inputs
Regressions an correlations can only #e -er+or$e !ith ata series that
contain a range o+ i++erent values"
2or e3a$-le, in the earlier case o+ the avertising e3-enses, the relationshi-
#et!een the changing avertising e3-ense an the changing sales +igures
allo!e a regression calculation to #e -er+or$e"
I+ the avertising e3-ense ha #een a constant +igure in each -erio, it !oul
not have #een -ossi#le to eter$ine !hether the avertising !as a++ecting the
sales +igures or not"
In so$e cases, a varia#le can #e eli#erately change in orer to eter$ine a
cause<an<e++ect"
)80
2or e3a$-le, the avertising $ay #e o-erate +or several $onths, halte +or a
-erio o+ ti$e, an then re<starte"
This $ay -rovie an o--ortunity to eter$ine !hether the sales +igures rose
o+ +ell in relation to the avertising, or !hether the avertising ha no
signi+icant e++ect"
This is one a--roach that $ay #e use to eter$ine the e++ectiveness o+ a
regular avertising ca$-aign, although care shoul #e taken to ensure that
any -ro+ile that has #een esta#lishe #y the #usiness oes not ecay to the
-oint !here it cannot #e resurrecte"
In general a change in o-erations $ay not #e $ae -urely +or the -ur-ose o+
eter$ining the e++ect that it $ay have on other issues"
=o!ever, the +act re$ains that the e++ect o+ one varia#le cannot #e truly
eter$ine unless it is change or re$ove"
Dhen this is one, the original in+luence o+ the varia#le $ay #e re+lecte in
the change that occurs +ollo!ing a change in the varia#le"
5.2.!. 'ppliations of probabilit$ an( statistis
Statistics can #e use !ithin #usiness situations in so$e o+ the +ollo!ing
conte3ts"
2inancial structure Average levels an variations in sales, cash +lo!s,
asset values an so on"
2inancial risk %3-osure o+ the #usiness to -otential loss ue to
volatile -rices, interest rate changes, +oreign e3change
rate changes an so on"
Manu+acturing 5rouct tolerances, +ault rates, etc"
Marketing Average res-onse rates to avertising, trial -rouct
launches, the s-rea o+ custo$er nu$#ers #et!een
lo!<volu$e, $eiu$<volu$e an high<volu$e service
usage an so on"
)8*
Statistics $ay #e heavily use in $anu+acturing"
2or e3a$-le, +oo ite$s are o+ten sol #y !eight"
Sa$-les o+ the co$-lete -roucts $ay #e selecte an !eighe, to ensure
that the average !eight o+ the -roucts $atche the !eight that !as s-eci+ie
in the -rouct escri-tion"
As another e3a$-le, $anu+acture steel -arts $ay #e -rouce to s-eci+ie
tolerances"
2or e3a$-le, a -art $ay have a s-eci+ie !eight o+ 1200 T 0 gra$s"
The actual !eight o+ iniviual ite$s $ay +ollo! a -attern that
a--ro3i$ately $atche a nor$al -ro#a#ility istri#ution"
5arts that !ere outsie the s-eci+ie tolerances $ay #e iscare, !ith the
$easuring accuracy o+ the $easuring e&ui-$ent also #eing relevant in
selecting the relevant set o+ -arts"
5.2.7. Ot.er statistial issues
5.2.7.1. +ombinations & permutations
In so$e situations, the nu$#er o+ co$#inations o+ a set o+ varia#les $ay
nee to #e eter$ine"
The +ollo!ing +or$ulas can #e use to calculate the nu$#er o+ co$#inations
o+ ite$s that $ay occur in several i++erent situations
Com"inations
Dhen several ite$s are selecte +ro$ a larger set o+ ite$s, the nu$#er o+
-ossi#le co$#inations can #e calculate +ro$ the +ollo!ing +or$ula
(>> co$#inations)
In this +or$ula, :n; is the nu$#er o+ ite$s that are selecte, an :k; is the
total nu$#er o+ ite$s"
)8)
In this calculation, the orer o+ the ite$s is not signi+icant, an a grou- o+
ite$s is counte as a single co$#ination, regarless o+ the orer in !hich
they are ra!n"
Permutations
A si$ilar calculation to the co$#inations value can #e calculate !hen the
orer o+ the ite$s is signi+icant"
In this case, a grou- o+ the sa$e ite$s is classi+ie as a se-arate set !hen the
ite$s a--ear in a i++erent orer"
The +ollo!ing +or$ula can #e use to calculate the nu$#er o+ -er$utations
o+ :n; ite$s selecte +ro$ a set o+ :k; ite$s
(>> -er$utations)
/ultiple varia"les
In so$e cases, such as -rouct o-tions, several varia#les $ay a--ly, !ith
each varia#le containing a nu$#er o+ -ossi#le values"
In these cases, the total nu$#er o+ co$#inations o+ the varia#les can #e
calculate using the +ollo!ing a--roach"
together multiplied ) iable var each for items of number ns combinatio
2or e3a$-le, i+ a -rouct containe three o-tions, !ith the +irst o-tion having
3 alternatives, the secon o-tion having 8, an the thir o-tion 0, then the
total nu$#er o+ -ossi#le -rouct co$#inations coul #e calculate using the
+ollo!ing a--roach"
0 8 3 ns combinatio
10
)88
5.2.8. #tatistial terms
Arith$etic average A central -oint in the set o+ nu$#ers, calculate
#y iviing the su$ o+ the nu$#ers #y the
nu$#er o+ ata -oints" This coul also #e
e3-resse in the +or$ that total value o+ the ata
series is e&ual to the arith$etic average
$ulti-lie #y the nu$#er o+ ata -oints" In
statistics this value is generally kno!n as the
:$ean;"
Average A central -oint !ithin the set o+ nu$#ers" The
ter$ :average; generally re+ers to the
:arith$etic average;"
Bivariate A--lying to t!o ata varia#les"
/oe++icient A nu$#er in an e&uation that is $ulti-lie #y a
varia#le" 2or e3a$-le, in the e&uation :sales P
1"2 3 avertising;, the value :1"2; is a
coe++icient"
/on+ience interval A range #ase on a $ini$u$ an $a3i$u$
value +or a statistical nu$#er such as an average,
!hich atte$-ts to $easure ho! accurate the
nu$#er is likely to #e" The !ith o+ the
con+ience internal reuces as the nu$#er o+
ata -oints increases, an increases as the
s-eci+ie re&uire accuracy is increase"
/orrelation A value that inicates the linear relationshi-
#et!een t!o ata sets" A correlation o+ 0
suggests that the ata sets are ine-enent, an
that a value is one ata set oes not a++ect a
value in the other ata set" /orrelation varies
#et!een <1, +or a -er+ect o--osite relationshi-,
to M1, +or a -er+ect -ositive relationshi-"
/ovariance A $easure o+ the relationshi- #et!een t!o ata
sets, that inclues the stanar eviation o+ each
ata set" The covariance is e&ual to the
:correlation 3 stanar eviation o+ set 1 3
stanar eviation o+ set 2;"
%sti$ation /alculating a statistical value such as an
average" In cases !here the nu$#ers $ay
re-resent -art o+ a larger set o+ values, the value
that is calculate is only an esti$ate o+ the value
that $ay a--ly to the +ull set o+ nu$#ers" 2or
e3a$-le, the volatility !ithin a $arket -rice can
)81
#e calculate +ro$ a set o+ -rices, ho!ever this
$ay not e3actly re+lect the actual volatility that
is causing the -rice changes"
%3-ectation The $ean o+ a rano$ varia#le" Also kno!n as
the :e3-ecte value;, although in so$e cases the
$ean is not e&ual to the value o+ any o+ the
-ossi#le outco$es"
(eo$etric average The :nth; root o+ the -rouct o+ :n; nu$#ers"
Dhen the geo$etric average is $ulti-lie #y
itsel+, it e&uals the total o+ the ata set, in
contrast to the arith$etic average, !hich $ust
#e ae to itsel+" The geo$etric average is use
+or ata sets that are $ulti-lie together, such as
invest$ent returns"
Kurtosis The +ourth $o$ent o+ a istri#ution, this is
calculate +ro$ averaging the values o+ the
eviation o+ each ata -oint +ro$ the $ean,
raise to the -o!er o+ 0" Kurtosis s-eci+ies ho!
large the :tails; o+ a istri#ution are, an
!hether e3tre$e events are $ore likely or less
likely than in alternative istri#utions"
,e-tokurtosis inicates that e3tre$e events have
a higher chance o+ occurring than a stanar
istri#ution !oul suggest" This is a co$$on
e++ect in so$e +inancial $arkets"
,inear istri#ution A istri#ution in !hich the -ro#a#ility o+ each
-ossi#le outco$e is e&ual, such as tossing a
coin"
Mean See :arith$etic average;"
Meian A -oint such that hal+ the ata set is less than the
$eian, an hal+ the ata set is larger than the
$eian" This is an alternative $easure o+ a
central -oint to the arith$etic average, an $ay
#e use+ul !hen a s$all nu$#er o+ ata -oints
are availa#le, or !hen the ata contains a large
nu$#er o+ outliers or errors"
Moe A ata value that occurs the $ost nu$#er o+
ti$es !ithin a large set o+ nu$#ers" This
statistical +igure is rarely use"
Mo$ent A -ro-erty o+ a -ro#a#ility istri#ution or a set
o+ nu$#ers, calculate #y averaging the
eviations +ro$ the $ean, raise to the s-eci+ie
-o!er" The $ean is the +irst $o$ent o+ a
istri#ution, variance is the secon $o$ent,
ske!ness is the thir $o$ent an kurtosis is the
)86
+ourth $o$ent"
Multivariate A--lying to t!o or $ore ata varia#les"
4or$al istri#ution A istri#ution that co$$only a--ears in
varia#les that are #ase on a large nu$#er o+
se-arate e++ects" 'alues !ithin one stanar
eviation o+ the $ean are co$$on, !hile
e3tre$e -ositive or negative nu$#ers have very
lo! -ro#a#ilities"
Autco$e A -ossi#le result +ro$ a trial, such as the
nu$#er 3 a--earing on a ice, or a sale in
res-onse to a sa$-le o+ -roucts"
Autlier A ata -oint that is $uch larger or s$aller than
$ost o+ the other ata -oints" This $ay #e an
error, or si$-ly an unusual occurrence" Autliers
$ay have a signi+icant i$-act on values such as
stanar eviation, an are so$eti$es re$ove
#e+ore statistical values are calculate"
5oisson istri#ution A -ro#a#ility istri#ution that s-eci+ies the
nu$#er o+ rano$ events that are likely to occur
!ithin a -erio o+ ti$e, such as the nu$#er o+
custo$ers arriving at a #usiness location !ithin
a -erio o+ ti$e"
5ro#a#ility The chance that an event !ill occur" Although
-ro#a#ility cannot -reict events, an event that
has a -ro#a#ility o+ 0"* !oul #e e3ce-te to
occur a#out hal+ the ti$e, i+ a large nu$#er o+
trials !ere conucte" 5ro#a#ility ranges
#et!een 0, +or an event that cannot occur, an 1,
+or an event that is certain to occur"
5ro#a#ility istri#ution A -attern o+ the -ro#a#ilities that a--ly to each
-ossi#le outco$e" The :nor$al istri#ution; is
the $ost !iely<occurring istri#ution in the
#usiness an +inance conte3t"
5rouct The result o+ $ulti-lying several nu$#ers
together" 2or e3a$-le, the -rouct o+ :a;, :#;
an :c; is e&ual to a 3 # 3 c"
Rano$ varia#le A value that can have rano$ values that cannot
#e eter$ine +ro$ -revious values" %3a$-les
$ay inclue the sales +igures +or a $onth, an
the -rice o+ a volatile co$$oity"
Rano$ !alk A ti$e series in !hich a -ro#a#ility istri#ution
o+ each value is centre on the -revious -oint in
the series, rather than a constant value" The -rice
o+ goos !ithin $arkets o+ten +ollo!s a rano$
!alk -attern"
)10
Regression A calculation that esti$ates a cause<an<e++ect
relationshi- #et!een t!o ata sets" This allo!s a
-reiction to #e $ae o+ a likely value in one
ata set, given a s-eci+ie value in the other ata
set"
Risk In the #usiness conte3t, a situation in !hich an
event $ay occur that !oul have a negative
i$-act on the #usiness" In the +inancial conte3t,
this is e3-osure to the -ossi#ility o+ a -ositive or
negative change in value, such as e3-osure to a
volatile -rice, or an uncertain cash +lo!"
R<s&uare The s&uare o+ a regression co<e++icient, !hich is
the regression coe++icient that is $ulti-lie #y
the +irst ata value" The r<s&uare inicates the
-ro-ortion o+ the secon ata set that $ay #e
cause #y $oves in the +irst ata set"
Sa$-le A set o+ nu$#ers that is use to calculate
statistical values, as an esti$ate o+ the values
that $ay a--ly to the +ull set o+ ite$s" 2or
e3a$-le, a sa$-le o+ $anu+acture ite$s $ay
#e !eighe to esti$ate the !eight o+ the average
-rouct in a large set o+ -roucts"
Sa$-le Bias A situation in !hich a set o+ statistical results
that have #een calculate +ro$ a sa$-le o not
re+lect the -ara$eters that e3ist !ithin the +ull
ata set, ue to the $etho that !as use to
select the sa$-le ata ite$s"
Seasonal a9ust$ent A9ust$ent to ti$e series in atte$-ts to re$ove
the e++ect o+ seasonal changes, so that a tren
rise or +all in the ata values can #e eter$ine"
Seasonally a9uste +igure are !iely use in
econo$ic ata"
Ske! The thir $o$ent o+ a istri#ution, calculate as
the average o+ the cu#e istances o+ each ata
-oint +ro$ the $ean" A sy$$etrical istri#ution
has a ske! o+ @ero" A negative ske! inicates
that the le+t sie o+ the istri#ution has a high
-ro-ortion o+ e3tre$e values, !hile a -ositive
ske! inicate that the right sie o+ the
istri#ution has a high -ro-ortion o+ e3tre$e
values"
Stationary A ti$e series in !hich the unerlying
istri#ution oes not change" 2or e3a$-le, i+ a
$arket -rice #eca$e $ore volatile +or an
e3tene -erio o+ ti$e, this !oul #e a non<
)11
stationary series"
Statistic A nu$#er that escri#es a -ro-erty o+ a set o+
nu$#ers, such as an average value"
Stochastic A -rocess that inclues rano$ ele$ents, an in
!hich the out-uts cannot #e -reicte +ro$ the
in-uts or +ro$ -revious events" In contrast, in a
eter$inistic -rocess, the out-uts can #e irectly
-reicte +ro$ the in-uts" The o-erating s-ee
o+ a $achine is a eter$inistic -rocess, !hile
the +ault rate is a stochastic -rocess"
Su$ The result o+ aing several nu$#ers together"
2or e3a$-le, the su$ o+ :a;, :#; an :c; is
e&ual to a M # M c"
Trial An action that generates an outco$e, such as
thro!ing a ice, or istri#uting sa$-le -roucts
!ithin a $arketing ca$-aign"
Hnivariate A--lying to a single ata varia#le"
'ariance The average o+ the s&uare eviation o+ each
ata -oint +ro$ the $ean" This is a $easure o+
ho! !iely s-rea the ata -oints are" Stanar
eviation is the s&uare root o+ the variance"
'olatility The stanar eviation o+ a ti$e series, such as a
series o+ $arket -rices"
Deight The signi+icance or i$-act o+ an iniviual
nu$#er !ithin a ata series" 2or e3a$-le, each
nu$#er !ith a ata series $ay s-eci+y a
-ro-erty o+ an o#9ect, !ith the si@e o+ each
o#9ect inicating the i$-act o+ the iniviual
nu$#er on the total value o+ the series"
Deighte average An average o+ a set o+ nu$#ers that a--lies a
se-arate !eight to each nu$#er in the average"
The !eighte average $ulti-lie #y the total o+
the !eights is e&ual to the su$ o+ each
iniviual nu$#er $ulti-lie #y its !eight"
)12
#.!. Specific ris+ management
5.3.1. #peifi ,is6s
Business risk involves the risk that events $ay have a negative i$-act on the
#usiness"
This coul occur suenly ue to a single event, or it $ay involve the graual
eterioration o+ the #usiness over ti$e"
(eneral #usiness risk $ay #e aresse through so$e o+ the +ollo!ing ste-s"
/reating a #usiness structure that is +le3i#le an e++ective"
Maintaining ae&uate levels o+ ca-ital an cash reserves"
Attening to $argins an cash +lo!"
Invest$ent in ne! -roucts an -ro9ects"
S-eci+ic risks involve the risk that a negative i$-act $ay occur to the
#usiness ue to a s-eci+ic event"
This $ay inclue changes to the $arket -rice o+ ra! $aterials or +inishe
-roucts, changes in +oreign e3change rates or interest rates, -ro9ects risks,
an losses ue to insura#le events such as #uilings #eing estroye #y +ire"
S-eci+ic risks $ay involve iniviual events, or they $ay involve a
continuous -rocess such as a volatile in-ut -rice"
In general, s-eci+ic risks can #e $anage as -otential cash +lo!s, o+ various
si@es an -ro#a#ilities, e-ening on the -articular situation"
)13
5.3.2. ,is6 E)posures
5.3.2.1. 7n(erl$ing E)posures
Hnerlying e3-osures involve e3-osures to risk that occur as -art o+ the
#usiness o-eration"
2or e3a$-le, i+ either a ra! $aterial or a +inishe -rouct traes !ith volatile
-rices, then the #usiness $ay #e e3-ose to the risk o+ a negative i$-act
cause #y rising ra! $aterials -rices, or +alling -rices +or +inishe goos"
/hanges in +oreign e3change rates $ay i$-act negatively on the #usiness i+
the #usiness i$-orts ra! $aterials or e&ui-$ent, or e3-orts +inishe
-roucts"
The risk o+ increases in interest rates $ay also re-resent a risk to the
#usiness, ue to the higher interest -ay$ents that $ay #e re&uire in this
case"
In the case o+ -ro9ects, risks $ay involve an uncertain value o+ +uture costs or
inco$e ue to changes in $arket -rices, interest rates an +oreign e3change
rates"
Also, the risk o+ the -ro9ect itsel+ $ay #e consiere, such as the risk that
-ro9ect stages !ill not #e co$-lete, or that costs an ti$e +ra$es !ill
eviate +ro$ the -ro9ect -lan !hen the -ro9ect is i$-le$ente"
A :long; e3-osure is an e3-osure in !hich a +all in the -rice !oul have a
negative i$-act on the #usiness"
A holing o+ a -hysical asset, an the sale -rice o+ a co$-lete -rouct, are
e3a$-les o+ long e3-osures"
A :short; e3-osure is an e3-osure in !hich a rise, rather than a +all, in the
-rice !oul have a negative i$-act on the #usiness"
The e3-osure o+ the #usiness to the risk o+ rising ra! $aterials costs is an
e3a$-le o+ a short -osition"
Instru$ents that involve t!o -arties, such as +utures, o-tions, an +i3e<-rice
su--ly contracts, are a long -osition +or one -arty an a short -osition +or the
other -arty"
)10
5.3.2.2. ,is6 instruments
Risk instru$ents involve contracts that create a risk +or the #usiness"
The risk create #y a risk instru$ent $ay increase risk to the #usiness, or it
$ay reuce the net risk #y o++setting an e3isting e3-osure"
Direct contracts
7irect contracts involve contracts #et!een the #usiness an custo$ers or
su--liers"
These $ay inclue agree$ents to conuct transactions on +uture ates, !ith
the -rice an contract etails #eing esta#lishe at the #eginning o+ the -erio"
This is kno!n as a +or!ar sale"
7irect contracts $ay also inclue o-tions an other e3-osures, such as a
elivery -rice that is e&ual to the $arket -rice, #ut !ith a $a3i$u$ an
$ini$u$ -rice range"
These contract structures $ay #e use to reuce the risk o+ rising in-ut values
or +alling out-ut values +or the #usiness"
Also, contract conitions $ay involve the #usiness taking on a -rice risk
+ro$ a custo$er or a su--lier, in return +or an altere -ay$ent uner the
contract ter$s"
-raded ,nstruments
Trae instru$ents involve contracts that can #e #ought an sol !ith other
-arties"
The contracts generally involve a si$-le structure, such as an agree$ent to
-urchase a +i3e &uantity o+ a stanar co$$oity on a +uture ate at a +i3e
-rice"
Trae instru$ents can #e use to hege e3isting risks, or +or traing an
s-eculative -ur-oses"
A :hege; involves entering a risk contract !ith an o--osite e3-osure to an
unerlying e3-osure, as a $etho o+ cancelling the e3isting risk"
)1*
Trae +utures an o-tions contracts are availa#le involving agricultural
co$$oities such as !heat an !ool, $ining co$$oities such as oil an
gol, +oreign e3change rates, an interest rates"
5.3.3. ,is6 4nstruments
5.3.3.1. Diret ontrats
+orwards
A +or!ar sale involves a contract to e3change goos +or -ay$ent, ho!ever
the actual e3change is set to occur on a istant +uture ate"
2or e3a$-le, a agricultural -roucer $ay conuct a +or!ar sale to a
$anu+acturer, !ith elivery to occur in si3 $onthCs ti$e a+ter the en o+ the
harvest season, an !ith -ay$ent to #e $ae at the sa$e ti$e"
A +or!ar sale involves a -rice #eing set at the ti$e that the initial contract is
create"
The risk to the #usiness that the $arket -rice $ay +all #e+ore the settle$ent
ate is eli$inate #y this arrange$ent"
A +or!ar sale coul #e vie!e as irectly eli$inating this -rice risk"
An alternative vie! $ay involve the unerlying $arket risk o+ the
co$$oity -rice re$aining, !ith the +or!ar contract re-resenting a
se-arate risk in the o--osite irection, !hich cancels the unerlying risk"
This vie! $ay #e use+ul in eter$ining -ricing +or contracts an unerlying
e3-osures, an in consiering issues such as the risk o+ e+ault on the
+or!ar contract"
Contract options
/ontract o-tions $ay involve a irect agree$ent !ith a custo$er or su--lier
to conuction an o-tional transaction, or to inclue an o-tion involving the
transaction -rice"
2or e3a$-le, a su--ly contract $ay involve an agree$ent to su--ly a
co$$oity at the current $arket -rice, u- to a $a3i$u$ -rice li$it"
)1)
This structure !oul e++ectively allo! the #uyer to choose the current $arket
-rice, or the +i3e o-tion -rice, !hichever !as lo!er"
A-tions $ay #e use #y the o-tion holer to reuce the e3-osure to certain
-rice $oves"
The value o+ the o-tion $ay #e inclue !ithin the contract, using $ethos
such as an aitional +ee, a higher average -rice, a $argin ae to the
$arket -rice or so$e other $echanis$"
Comple% arrangements
Su--ly contracts $ay also involve $ore co$-le3 risk structures, such as
-rice ranges, transaction that occur uner i++erent conitions, an so on"
In these cases, the value o+ the risk conition is e&ual to the average trans+er
o+ value that !oul occur, consiering the -ro#a#ilities o+ various -rices an
events occurring"
Methos such as co$-uter si$ulations $ay #e necessary to eter$ine a
value +or these contracts"
In so$e cases, the value o+ a contract $ay #e esti$ate +ro$ current
conitions, rather than +ro$ a statistical analysis"
5.3.3.2. Tra(e( instruments
Trae instru$ents involve stanarise contracts that are trae on stock
an +utures e3changes"
These contracts $ay #e use +or risk $anage$ent an +or s-eculative
-ur-oses"
Si$ilar contracts $ay also #e arrange irectly !ith other -arties in so$e
circu$stances, !hich are kno!n as :over<the<counter; instru$ents
)18
5.3.3.2.1. T$pes of tra(e( instrument
5.3.3.2.1.1. Options
A trae o-tion is a generally a contract than inclues the right to #uy or to
sell a +i3e &uantity o+ a co$$oity +or a +i3e -erio o+ ti$e, at a +i3e
-rice"
A :call; o-tion involves the right to #uy a co$$oity, !hile a :-ut; o-tion
involves the right to sell a co$$oity"
The o-tion #uyer $ay chose to e3ercise the o-tion, in !hich case the
s-eci+ie transaction -rocees"
I+ the o-tion holer takes no action, the o-tion la-ses, an no transaction
occurs"
The -arty that creates the o-tion is kno!n as the o-tion !riter, an $ust
conuct the transaction i+ the o-tion holer e3ercises the o-tion"
The :strike -rice; o+ an o-tion is the +i3e -rice at !hich the unerlying
transaction !oul occur i+ the o-tion !as e3ercise"
An :A$erican style; o-tion can #e e3ercise at any ti$e !ithin the o-tion
-erio, !hile a :%uro-ean style; o-tion can only #e e3ercise on the +inal
ay o+ the o-tion -erio"
These ter$s o not re+er to geogra-hical locations, an #oth styles o+ o-tion
are trae in various -laces an circu$stances"
The ter$ o+ an o-tion is generally in the range o+ several $onths"
A-tions can #e a +le3i#le an use+ul risk $anage$ent tool, as they allo! the
-rice e3-osure o+ the #usiness to #e altere to $atch a range o+ i++erent
-atterns"
In contrast, +i3e -rice agree$ents si$-ly allo! the total risk to #e raise or
lo!ere, rather than altering the -attern o+ e3-osure that $ay occur at
i++erent -rice levels"
As an e3a$-le o+ interest rate risk, a -ay$ent o+ G100 $ay #e e3-ecte in si3
$onthCs ti$e"
At that ti$e, the -ay$ent $ay #e investe in govern$ent #ons"
)11
A call o-tion coul #e -urchase to allo! the -urchase o+ G100 o+
govern$ent #ons in si3 $onthCs ti$e, at a current interest rate o+ 1L"
This o-tion $ay allo! the #usiness to hege the risk that interest rates $ay
+all #e+ore the -ay$ent is receive"
A-tions $ay #e use to $anage -rice risk"
Also, o-tions can #e use in situations in !hich a transaction $ay or $ay not
occur"

2or e3a$-le, a #usiness $ay su#$it a +i3e<-rice tener +or a -ro9ect"
An o-tion coul then #e -urchase, to allo! the ra! $aterials to #e
-urchase at a +i3e -rice i+ the tener !as selecte to co$-lete the -ro9ect"
As an e3a$-le o+ an o-tion, the +ollo!ing ta#le lists a set o+ -ossi#le results
at the e3-iry ate +or a call o-tion !ith a strike -rice o+ G100"
Market 7elivery 7elivererCs ReceiverCs
5rice 5rice 'alue /hange 'alue /hange
1* 1* 0 0
60 60 0 0
6* 6* 0 0
100 100 0 0
10* 100 <* M*
110 100 <10 M10
11* 100 <1* M1*
5.3.3.2.1.2. /utures
A +utures contract is a stanarise +or!ar sale contract that is trae on a
+utures e3change"
A +utures contract involves entering a contract to #uy or sell a +i3e &uantity
o+ a co$$oity at a +i3e -rice on a +uture ate"
4o cost is involve in entering a +utures transaction"
)16
There generally is an e&ual -ro#a#ility o+ a -ro+it or a loss occurring on a
+utures -osition, an there is no trans+er o+ risk +ro$ one -arty to the other"
A +utures contract can #e use to take on a risk o+ the o--osite irection to an
unerlying risk, an so to cancel the unerlying risk"
2or e3a$-le, an agricultural -roucer $ay -urchase a +utures contract to sell
a &uantity o+ a co$$oity on a +uture ate, at a +i3e -rice"
Ance the contract is entere, changes in $arket -rices !ill lea to a -ositive
or negative value arising +or the +utures contract, as the +utures contract $ay
involve a sale occurring at a -rice that is a#ove or #elo! the current $arket
-rice !hen the transaction occurs on the e3-iry ate o+ the contract"
This -ro+it or loss !oul #alance the o--osite rise or +all in the $arket value
o+ the unerlying co$$oity hel #y the #usiness"
A +utures contract can #e :close out; -rior to $aturing, #y entering a secon
+utures contract o+ the o--osite irection, an realising the current -ro+it or
loss on the -osition"
A :$argin; involves a -ay$ent that is loge !ith a #roker to $atch a
current loss -osition"
Margins on +utures contracts $ust #e u-ate aily, an are use to reuce
the creit risk o+ a client e+aulting on a +utures contract"
The +ollo!ing ta#le -resents an e3a$-le o+ so$e -ossi#le results on the
e3-iry ate o+ a +utures contract"
The +utures contract -rice in this e3a$-le is G100"
Market 7elivery 7elivererCs ReceiverCs
5rice 5rice 'alue /hange 'alue /hange
1* 100 M1* <1*
60 100 M10 <10
6* 100 M* <*
100 100 0 0
10* 100 <* M*
110 100 <10 M10
11* 100 <1* M1*
)60
5.3.3.2.1.3. #5aps
A :s!a-; is an instru$ent that involves e3changing a series o+ interest
-ay$ents at a +i3e interest rate, +or a series o+ interest -ay$ents at a +loating
interest rate"
The net i++erent #et!een the +i3e interest rate -ay$ent an the +loating
interest -ay$ent is e3change on each interest -ay$ent ate"
A s!a- can #e use to change the #usinessCs e#t +ro$ a +i3e interest rate
structure to a +loating interest rate structure, !ithout altering the loans
the$selves"
5.3.3.2.2. E).ange tra(e( instruments
%3change trae instru$ents are stanarise o-tions, +utures an other
instru$ents that are trae on stock or +utures e3changes"
This a--roach allo!s -ositions to #e o-ene an close at any ti$e,
assu$ing that there is a reasona#le level o+ traing volu$e occurring in the
instru$ent"
A nu$#er o+ $ethos are use to conuct traing on e3changes"
Bid-and-offer e%changes
The #i<an<o++er syste$ involves #uyers loging #is an sellers loging
o++ers to sell"
%ach #i or o++er s-eci+ies a -rice an a &uantity o+ the co$$oity to #uy or
sell"
There is generally a s$all ga- #et!een the highest #i an the lo!est o++er,
kno!n as a :#i<o++er s-rea; or the :#i<ask s-rea;"
A transaction occurs !hen one -arty acce-ts a current #i or o++er o+ another
-arty"
Bi<an<o++er syste$s are co$$only use +or stock e3changes
)61
1pen outcr* e%changes
In an o-en outcry syste$, traing takes -lace !ithin a large roo$"
A client orer is announce in a s$all area kno!n as a traing -it"
Ather #rokers call out o++ers, an a+ter a short -erio o+ negotiation, a eal
-rice is struck an the ne3t orer is announce"
A-en outcry syste$s are co$$only use in co$$oity e3changes, an also
in +utures e3changes"
Dealer markets
In ealer $arkets, +ull<ti$e ealers !ithin the $arket are allocate a set o+
instru$ents"
The ealer then &uotes a #uy an a sell -rice !hen an investor a--roaches the
$arket to trae"
This $ay involve o++ering to create o-tions or to #uy o-tions"
In the case o+ securities, the ealer $ay hol a -ort+olio o+ securities to allo!
securities to #e sol to an investor !hen an investor re&uests a &uote +or a
selling -rice"
This syste$ $ay #e co$#ine !ith #is an o++ers that are loge irectly in
the $arket #y #uyers an sellers"
7ealer $arkets are use in situations !ere a lo! volu$e o+ traing $ay
occur, such as stock e3changes that s-ecialise in traing the shares o+ s$all
co$-anies"
5.3.3.2.3. Over*t.e*ounter instruments
An over<the<counter instru$ent involves +or!ar transactions, o-tions an
other instru$ents that are irectly arrange !ith a counter-arty, generally a
#ank"
)62
2or e3a$-le, a #usiness $ay #e e3-ecting to $ake a large +oreign e3change
-ay$ent on a certain ate in the +uture"
A +or!ar transaction coul then #e arrange !ith a #ank, to +i3 the
e3change rate at the current level, an to reuce the risk o+ a loss occurring
ue to a change in the +oreign e3change rate"
Aver<the<counter instru$ents can #e custo$ise to the re&uire$ents o+ a
-articular transaction"
=o!ever, an over<the<counter contract $ay #e $ore i++icult to arrange than
an e3change<trae contract, as the counter-arty $ay #e e3-ose to the creit
risk o+ the #usiness"
Also, closing an over<the<counter -osition $ay involve o#taining a &uote
+ro$ the counter-arty to un!in the contract"
In so$e $arkets, a :t!o !ay -rice; is &uote"
This involves the client no$inating a transaction, an the counter-arty
&uoting #oth a #uy an a sell -rice +or the transaction"
2or e3a$-le, a #ank $ay &uote a -rice o+ G8) to sell an o-tion to a client an
G8* to #uy the o-tion +ro$ the client"
A t!o<!ay &uote allo!s the #usiness to eter$ine the +ee s-rea that is
e$#ee !ithin the &uote, #e+ore eciing !hether to -rocee !ith the
transaction"
5.3.4. 3riing a ris6
5ricing a risk involves calculating a value +or an e3-osure or an instru$ent
such as an o-tion"
The e++ective value o+ an uncertain cash +lo! is e&ual to the average trans+er
than !oul occur, consiering the -ro#a#ilities o+ the situation"
This -rinci-le a--lies to all risks an uncertain cash +lo!s, no $atter ho!
co$-le3 the instru$ent or the situation"
This -rinci-le also a--lies to uncertain asset values, as !ell as uncertain cash
+lo!s"
)63
1ptions
The value o+ an o-tion is e-enant on -ro#a#ilities"
A trae o-tion cannot have a negative or @ero value, as no loss can occur +or
a holer o+ an o-tion, ho!ever a -ro+it coul occur in certain circu$stances"
+utures
The value o+ a +utures contract is @ero at co$$ence$ent"
The +utures -rice sta#ilises at a level !here the $arket consensus vie!
+orecasts an e&ual -ro#a#ility o+ the $arket -rice o+ the co$$oity #eing
a#ove or #elo! the +utures -rice at the e3-iry o+ the contract"

5ro#a#ilities are not involve in valuing a +utures or a +or!ar -osition, at it
is assu$e that the -ro#a#ilities are incor-orate !ithin the current +utures
-rice"
The +utures -rice at co$$ence$ent is generally close to the current $arket
-rice o+ the co$$oity"
A+ter the co$$ence$ent o+ the contract, the value o+ a +utures -osition is
#ase on the i++erence #et!een the contract -rice an the current +utures
-rice, !hich is generally close to the $arket -rice"
1ther instruments
The value o+ other risk instru$ents, in aition to +utures an o-tions, is also
e&ual to the average value trans+er that !oul occur, consiering the
-ro#a#ilities o+ the -ossi#le -rice $oves"
A nu$#er o+ $ethos $ay #e use to esti$ate the value o+ a risk e3-osure or
a risk instru$ent"
This $ay inclue so$e o+ the +ollo!ing $ethos"
5.3.4.1. 'nal$tial met.o(s
Analytical $ethos involve calculations using $athe$atical e&uations"
)60
This $ay inclue the +ollo!ing a--roaches +or s-eci+ic risk circu$stances"
Single cash flow
In the case o+ a single cash +lo! that $ay or $ay not occur, the e++ective
value o+ the cash +lo! can #e calculate using the +ollo!ing +or$ula"
amount y probabilit value
This e&uation s-eci+ies a +una$ental relationshi-, an a--ears in $any
areas o+ #usiness an +inance"
2or e3a$-le, an ite$ o+ e&ui-$ent $ay #e insure +or G*0 !ith the
-ro#a#ility o+ loss or estruction o+ the e&ui-$ent #eing 0"03"
In this case, the value o+ the -olicy coul #e calculate using the +ollo!ing
e3a$-le"
*0 03 0 . value
*0 1. 5
aria"le cash flow si7e
In the case !here a cash +lo! or an asset value coul have several -ossi#le
values, the +ollo!ing +or$ula $ay #e use to calculate the e++ective value"
value possible each for ' amount y probabilit ' of sum value
This is the !eighte average o+ the -ossi#le values, !ith the -ro#a#ility o+
each value occurring #eing use as the !eight"
2or e3a$-le, the +ollo!ing +igures $ay #e esti$ate +or a ne! -rouct
launch
)6*
'alue 5ro#a#ility
00 20L
)0 80L
10 10L
The value o+ the -rouct coul then #e esti$ate using the +ollo!ing
calculation"
1 0 10 8 0 )0 2 0 00 . . . value + +
*1 5
The -revious e3a$-le o+ the e&ui-$ent insurance -ay$ent coul also #e
vie!e as a set o+ -ossi#le outco$es"
2or e3a$-le, the +ollo!ing outco$es $ay #e -ossi#le
Autco$e /ash 2lo! 5ro#a#ility
,oss or estruction *0 0"03
4o loss 0 0"68
In this case, the value o+ the insurance -ay$ent coul #e calculate using the
+ollo!ing e3a$-le"
68 0 0 03 0 *0 . . value average +
*0 1. 5
The +or$ula +or a single event that $ay or $ay not occur is a si$-li+ie case
o+ the general +or$ula o+ !eighte averages, an a--lies !hen a single +i3e
value $ay or $ay not occur"
)6)
aria"le cash flow with continuous values
In the case o+ values #ase on continuous varia#les, such as $arket -rices,
there $ay #e a -otentially unli$ite nu$#er o+ -ossi#le values +or a cash
+lo!"
In this case, the e++ective value o+ the cash +lo! re$ains e&ual to the su$ o+
each value $ulti-lie #y the -ro#a#ility o+ the value occurring, ho!ever
calculation $ay #e $ore i++icult than !ith a +inite nu$#er o+ -ossi#le
values"
In so$e cases, a $oel #ase on a -ro#a#ility istri#ution $ay #e use"
Also, $oels #ase on iviing the -rices into a large nu$#er o+ se-arate
values, or using si$ulation a--roaches, $ay #e use to esti$ate a value +or
the risk"
1ption pricing
A $athe$atical e&uation kno!n as the Black . Scholes o-tion -ricing
$oel can #e use to calculate the value o+ stanar o-tions contracts"
This $oel is #ase on the -ro#a#ilities o+ the nor$al -ro#a#ility
istri#ution"
The Black . Scholes $oel can #e use in any circu$stances !here the
volatility o+ the unerlying co$$oity -rice can #e esti$ate"
This calculation is -resente in section #eginning on -age 1062"
5.3.4.2. -o(elling
Moelling a--roaches involve using a co$-uter $oel to calculate a value
+or the e3-osure"
This can #e one using stanar so+t!are such as s-reasheet -rogra$s, or
through !riting -rogra$s s-eci+ically to -er+or$ the calculations involve in
valuing the instru$ent"
)68
Ane a--roach $ay involve iviing the -ossi#le +inal -rices into a large
nu$#er o+ s$all #ans, an calculating the value o+ the -osition !ithin each
#an"
The value o+ the e3-osure !oul then #e e&ual to value trans+er in each #an,
$ulti-lie #y the -ro#a#ility o+ the -rice a--earing in the #an, an totalle
across all the -rice #ans"
The -ro#a#ility coul #e esti$ate +ro$ the nor$al istri#ution, #ase on the
nu$#er o+ stanar eviations o+ the -rice $ove +ro$ the current -rice to the
-rice at the start an the en o+ each #an"
Moelling a--roaches can #e use in cases !here there are a s$all nu$#er o+
in-ut varia#les
5.3.4.3. #imulation
Si$ulation a--roaches involve -roucing a set o+ -ossi#le out-ut results, an
calculating a value +or the e3-osure +ro$ the average value o+ the results"
An :historical si$ulation; involves using -ast -rices as in-uts to the
si$ulation calculation"
A :Monte /arlo; si$ulation involves generating a large nu$#er o+ rano$
in-ut -rices, in a si$ilar -ro#a#ility istri#ution to the e3-ecte in-ut -rices"
Si$ulation a--roaches can #e use to value co$-le3 instru$ents, in cases
!here there are a large nu$#er o+ in-ut varia#les, an +or -ath<e-enant
-ositions, !here the value $ay e-en o+ the -ath that !as +ollo!e #y the
in-ut -rices, as !ell as the +inal values"
Si$ulation a--roaches are o+ten use in valuing -ro9ects"
2or e3a$-le, a $ining -ro9ect valuation $ay #e #ase on generating rano$
values +or the $arket -rices o+ the co$$oities, su--ly costs such as +uel
costs, an the a$ount o+ the $ineral +oun !ithin the $ine ore"
In other cases, a set o+ +i3e assu$-tions $ay #e use, or a set o+ #est<case,
!orst<case an average<case +igures $ay #e use to eter$ine a set o+
scenarios an to calculate a range o+ valuations"
)61
5.3.4.4. #ummar$ of ris6 priing approa.es
Analytical calculations Deighte average o+ the -ossi#le outco$es"
The Black . Scholes o-tion -ricing $oel"
Moelling /o$-uter<#ase $oels o+ the instru$ent value,
such as iviing -rice levels into #ans an
calculating the value in each #an"
Si$ulation =istorical si$ulation, #ase o+ results o+
valuations using -ast -rices as in-uts"
Monte /arlo si$ulation, using rano$ -rices as
in-uts to generate a -ro#a#ility istri#ution an
average out-ut +igure"
)66
5.3.5. +apital alulations
In cases !here risk instru$ents are hel, ca-ital $ust generally #e set asie
to $eet the -ossi#le -ay$ents that $ay #e re&uire"
This inclues -ositions such as +utures -ositions, !here losses $ay occur,
an !ritten o-tions, !here the #usiness $ay #e re&uire to conuct a
transaction i+ the o-tion is e3ercise"
5.3.5.1. -a)imum losses
In so$e cases, the $a3i$u$ loss that coul occur can #e calculate"
2or e3a$-le, the $a3i$u$ loss that coul occur on a -hysical holing o+ an
asset or a co$$oity !oul occur i+ the $arket value +ell to @ero"
In other cases, the -otential loss $ay #e unli$ite"
2or e3a$-le, the e3-osure to a ra! $aterial -rice is -otential unli$ite, as a
-rice can only +all to @ero, ho!ever the in-ut -rice o+ a ra! $aterial coul, in
theory, rise to an in+inite -rice"
In cases !here a -otential loss is unli$ite, an e3tre$e -rice $ove, such as a
ou#ling o+ the -rice !ithin a short -erio o+ ti$e, coul #e use +or a
$a3i$u$ loss calculation"
The $a3i$u$ loss on a -osition can #e calculate using the +ollo!ing
a--roach"
price mar$et (orstcase at value value current loss imum max
The total -otential loss $ay #e eter$ine #y calculating the $a3i$u$ loss
o+ each instru$ent, an su$$ing the total"
/a%imum losses and current values
800
The $a3i$u$ loss that can occur !ith a -hysical asset is e&ual to the total
value o+ the asset"
In the case o+ co$-any structures, the $a3i$u$ loss is also e&ual to the
value o+ the share -rice"
=o!ever, in the case o+ -ositions such as short +utures -ositions an !ritten
o-tions -ositions, the $a3i$u$ loss $ay #e signi+icantly larger that the
current value o+ the -osition"
In the case o+ #usiness activities conucte in an iniviual na$e or as a
-artnershi-, the $a3i$u$ loss $ay also #e larger than the a$ount investe"
Practical losses
In $any cases the $a3i$u$ loss $ay #e larger than the -ractical loss that
$ay #e likely to occur"
2or e3a$-le, the $arket -rice o+ a co$$oity $ay #e unlikely to +all to
@ero"
=o!ever, a $arket -rice $ay ro- signi+icantly, an in the case o+ assets
such as shares, a @ero value $ay #e a realistic -ossi#ility"
Dhen $any ine-enent risks are hel, such as #ank loans an insurance
-olicies, the -ro#a#ility o+ all risks entering loss<$aking -ositions at the
sa$e ti$e $ay #e s$all"
=o!ever, the $a3i$u$ risk e3-osure $ay highlight the relative i$-ortance
o+ risk $anage$ent calculations an a--roaches !ithin the $anage$ent o+
the #usiness"
5.3.5.2. /un(ing approa.es
5.3.5.2.1. /ull fun(ing
In cases !here a s$all nu$#er o+ -ay$ents $ay #e re&uire, the +ull value o+
the -ay$ents $ay #e set asie to $eet the -ossi#ility o+ -ay$ents #eco$ing
ue"
801
5.3.5.2.2. 3artial fun(ing
In cases !here a large nu$#er o+ ine-enent risks are hel, or the chance o+
a co$-lete loss $ay #e lo!, an only -art o+ the $a3i$u$ -ossi#le loss $ay
#e set asie to $eet -ossi#le -ay$ents"
The level o+ ca-ital $ay #e #ase on e3-erience, the traing history o+ the
o-eration, an current $arket conitions"
Statistical a--roaches $ay also #e use in eter$ining ca-ital levels"
T!o $a9or a--roaches are the value<at<risk $etho, an the elta<!eighting
$etho"
5.3.5.3. +alulating apital levels
5.3.5.3.1. :alue at ris6
A value<at<risk a--roach involves assu$ing a certain -rice $ove$ent, an
eter$ining the loss that !oul occur at that -rice $ove$ent"
The loss +igure $ay then #e use to eter$ine the level o+ ca-ital that $ay #e
set asie"
2or e3a$-le, a 1L -ro#a#ility level $ay #e chosen"
Base on the nor$al -ro#a#ility istri#ution, an re+erring to ta#le in 2igure
1 on -age ))0, there is a--ro3i$ately a 1L -ro#a#ility o+ a -rice $ove$ent
o+ $ore than 2"2 stanar eviations occurring over the ti$e +ra$e o+ the
stanar eviation calculation"
This +igure coul #e use to eter$ine a ne! -rice as an in-ut to a valuation
$oel, to eter$ine the loss that $ay occur uner an e3tre$e -rice $ove"
Alternatively, an e3tre$e -ercentage $ove$ent #ase on a $arket crash $ay
#e use, such as a 3*L ro- in the current -rice o+ a co$$oity or asset"
Si$ulation a--roaches can also #e use to eter$ine value<at<risk"
Hner these a--roaches, a -ro#a#ility istri#ution o+ the -ro+it or loss $ay #e
eter$ine, !ith the $a3i$u$ loss u- to a certain -ro#a#ility level #eing
calculate"
802
5.3.5.3.2. Delta 5eig.ting.
7elta !eighting involves calculating a +igure kno!n as the :elta; +or each
instru$ent"
The elta o+ an instru$ent is the instru$entCs sensitivity to the -rice
$ove$ents o+ the unerlying co$$oity"
A elta can #e calculate using the +ollo!ing a--roach
price input the in change small a
price output the in change the
delta
7elta is #ase on a ollar change, not a -ercentage change"
2or e3a$-le, an instru$ent $ay have a elta o+ 0"*"
In the case that a -rice o+ the unerlying e3-osure $ove #y G0, +or e3a$-le,
then the -rice o+ the instru$ent $ay change #y G2"
The $a3i$u$ loss is then calculate +ro$ the elta, $ulti-lie #y the change
in the in-ut -rice"
The in-ut -rice coul #e eter$ine +ro$ a certain -ercentage change,
assu$ing a conition such as a $arket crash, or +ro$ the nor$al -ro#a#ility
istri#ution, assu$ing a change such as a 2"* stanar eviation rise or +all"
=o!ever, the elta<!eighting $etho shoul #e use !ith caution"
This $etho is only strictly accurate !hen the elta is a constant value"
7elta is a constant value +or +utures an shares, #ut not +or o-tions, an not
+or $any other instru$ents"
In cases !here the elta itsel+ varies !ith the -rice level, this $etho $ay #e
use+ul in $anaging general traing activity, ho!ever it $ay not -rovie an
accurate esti$ate o+ the e++ective risk e3-osure or an instru$ent or a
-ort+olio"

803
2or e3a$-le, the +ollo!ing ta#le -resents a set o+ +igures +or a range o+
-ossi#le losses on an o-tion -osition"
These +igures inclue the -reicte loss using the elta<!eighte $etho, an
also using the actual loss that !oul have occurre"
Market 5rice 11*
A-tion 5rice 100
7elta 0"2
3rie 3re(ite( 'tual
8oss 8oss
115 " "
11" 1 "
1"5 2 "
1"" 3 "
95 4 5
9" 5 1"
85 ! 15
8" 7 2"
75 8 25
7" 9 3"
!5 1" 35
!" 11 4"
5.3.!. ,is6 portfolios
A risk -ort+olio involves a co$#ination o+ several se-arate e3-osures"
These coul inclue loans hel #y #anks, risks hel #y insurance co$-anies,
an trae instru$ents hel !ithin heging -ort+olios"
Ine-enent risks involve risks in !hich the -ro#a#ility o+ a change in the
value o+ one risk is not a++ecte #y a change on the value o+ another risk"
800
2or e3a$-le, this $ay #roaly a--ly to risks such as e#t e+aults, insurance
-ay$ents, an instru$ents trae in !iely i++erent $arkets"
=o!ever, it $ay not a--ly to instru$ents that are trae in the sa$e $arket
an $ay ten to rise or +all in -arallel"
In a -ort+olio co$-ose o+ ine-enent risks, the volatility o+ the total
-ort+olio $ay reuce in line !ith the s&uare root o+ the nu$#er o+ risks
!ithin the -ort+olio"
The +ollo!ing ta#le -resents the volatility o+ a -ort+olio o+ ine-enent risks,
!here each risk has the sa$e stanar eviation an the sa$e !eight !ithin
the -ort+olio"
=umber :olatilit$
of ris6s
1 1""<
2 71<
3 58<
4 5"<
5 45<
1" 32<
5" 14<
1"" 1"<
1""" 3<
2or e3a$-le, a -ort+olio o+ three risks in this case $ay have a volatility o+
only *1L o+ the volatility o+ an iniviual risk"
This occurs ue to the +act that so$e risks $ay rise !hile others $ay +all,
!hich $ay ten to cancel out the net $ove, an lea to a lo!er volatility +or
the total -ort+olio value"
The e3-ecte stanar eviation o+ a -ort+olio can #e calculate +ro$ the
stanar eviations o+ the iniviual risks, !here these +igures can #e
esti$ate"
The +or$ula +or calculating the stanar eviation o+ a -ort+olio o+ risks is
-resente in section #eginning on -age 1063"
80*
5.3.7. E)posure positions
5.3.7.1. +ombine( positions
In so$e cases, a risk -osition $ay #e $ore co$-le3 than a stanar o-tion or
+or!ar sale"
2or e3a$-le, one e3-osure -osition use in heging is kno!n as a :collar;"
A collar involves a trae occurring at a $arket -rice, #ut !ith a $ini$u$
an $a3i$u$ -rice value"
As an e3a$-le, a su--ly contract $ay s-eci+y that the -roucts !ill #e
su--lie at the current $arket -rice, #ut !ith a $ini$u$ -rice o+ G1 an a
$a3i$u$ -rice o+ G11"
/o$#ine -ositions $ay e3ist !ithin irect contracts #et!een su--liers an
custo$ers, or they can #e create #y holing several se-arate instru$ents"
2or e3a$-le, the collar in the -revious e3a$-le coul #e create #y #uying a
call o-tion !ith a strike -rice o+ G11, an !riting a -ut o-tion !ith a strike
-rice o+ G1"
I+ the $arket -rice +ell !ithin the range o+ G1 to G11, a stanar -urchase at
the $arket -rice coul #e conucte"
I+ the -rice at the en o+ the -erio !as a#ove G11, then the call o-tion coul
#e e3ercise to ena#le the -urchase to #e $ae at the G11 -rice"
Alternatively, i+ the $arket -rice at the en o+ the -erio !as #elo! G1, the
-ut o-tion $ay #e e3ercise against the #usiness, an elivery !oul #e
acce-te at the G1 -rice"
/o$#ine -ositions can #e value #y valuing each iniviual co$-onent o+
the -osition, an aing or su#tracting the values to eter$ine the net cost o+
the -osition"
5.3.7.2. +omple) positions
80)
In so$e situations, $ore co$-le3 -ositions $ay #e create, that cannot #e
value using stanar o-tions valuation a--roaches"
2or e3a$-le, a contract -rice $ay #e #ase on an average -rice over a
-erio, or the $ini$u$ or $a3i$u$ -rice that occurre uring a -erio"
5ositions such as these $ay #e inclue in so$e trae instru$ents, in over<
the<counter instru$ents, an in irect contracts"
In these cases, a si$ulation a--roach $ay #e necessary to e++ectively value
the e3-osure"
5.3.7.3. Bu$ing & selling upsi(e ris6
An o-tion -osition involves a -otential #ene+it to the o-tion holer, an a
corres-oning -otential loss to the o-tion !riter"
2or e3a$-le, a call o-tion $ay involve the right to #uy a co$$oity at a G10
-rice"
I+ the -rice !as a#ove G10, the o-tion holer $ay e3ercise the o-tion an #uy
the co$$oity at a -rice that !as #elo! the current $arket -rice"
/onversely, i+ the -rice !as #elo! G10, the o-tion $ay #e allo!e to la-se
an a transaction coul #e conucte at the current $arket -rice"
An o-tion cannot have a negative value, an an o-tion holer cannot su++er a
loss through holing an o-tion, a-art +ro$ the cost that $ay have #een
involve in entering the -osition"
In e++ect, #uying an o-tion involves -urchasing the chance o+ a -ro+it, !hile
!riting an o-tion involves giving u- the chance o+ a -ro+it, or acce-ting the
chance o+ a loss, in return +or -ay$ent"
2or e3a$-le, in the case o+ a collar !ithin a -rice range o+ G1 to G10, the
#usiness -urchases a call o-tion at G10 in orer to -rotect +ro$ a -ossi#le
loss i+ the -rice o+ the ra! $aterial rises a#ove G10"
This involves -urchasing an o-tion that !oul have a -ositive value i+ the
$arket -rice !as a#ove G10, that !oul o++set the loss that !oul have
occurre through -urchasing the $aterials at the higher -rice"
808
This is kno!n as :#uying u-sie;, as the #usiness -urchases the chance o+ a
-ro+it<$aking -osition a--earing"
:H-sie; re+ers to a -ositive return, not to a rising -rice"
A -ositive return $ay occur +ro$ either a rise or a +all in a -rice, e-ening
on !hether the e3-osure is a long -osition or a short -osition"
The #usiness is also e3-ose to a -otential #ene+it i+ the -rice o+ the su--lies
+ell to a lo! level"
This #ene+it can #e sol"
2or e3a$-le, !riting the -ut o-tion at the G1 level involves receiving inco$e
+ro$ !riting the o-tion"
I+ the $arket -rice +ell #elo! G1, the -ut o-tion $ay #e e3ercise, an the
#usiness !oul receive the $aterials at a sale -rice o+ G1, rather than the
lo!er $arket -rice"
In e++ect, the #usiness is giving u- the -ossi#ility o+ -urchasing the $aterials
at a -rice #elo! G1, in return +or -ay$ent"
This is kno!n as :selling u-sie;"
I+ the value o+ the t!o o-tions is e&ual, then this structure is kno!n as a :@ero
cost collar;"
In this situation, the collar can #e create +or a @ero cost"
2or e3a$-le, the $arket -rice o+ a co$$oity $ay currently #e G1*"
A -ut o-tion $ay #e !ritten !ith a strike -rice o+ G13, an the inco$e +ro$
!riting the o-tion coul #e use to -urchase a call o-tion !ith a strike -rice
o+ G18"
This !oul lock the +inal -urchase -rice +or the $aterial into the range o+ G13
to G18"
The #ene+it o+ eli$inating the risk o+ the -rice rising a#ove G18 !oul have
#een -ai +or #y giving u- the -ossi#ility o+ -urchasing the $aterials #elo!
the G13 $ini$u$ cost o+ the collar"
801
Alternatively, a +utures -osition is also a @ero cost -osition, as this involves
+i3ing the +uture -rice at the current ti$e, an the lost risk o+ -otential
o!nsie is e&ual to the lost #ene+it o+ -ossi#le u-sie"
5.3.8. 3ratial ris6 issues
5.3.8.1. #tabilit$ an( ris6
In so$e situations, conitions that have re$aine sta#le +or long -erios o+
ti$e $ay change suenly an une3-ectely"
2or e3a$-le, in the Hnite States, the -rice o+ gol !as +i3e as GHS 32
ollars -er ounce +or $any years, !hen gol !as use as a #acking +or the
HS currency"
The -rice o+ gol !as +loate in ?? (>> check year), an ra-ily rose to
levels o+ aroun (>> check +igures)"
7uring the 1680Cs the -rice o+ oil rose shar-ly an #eca$e highly volatile,
!hile in the late 1610Cs Australian interest rates rose to -reviously unhear o+
levels, !ith +loating interest rates reaching 18L (>>check +igures)"
In so$e res-ects, the -ossi#ility o+ a suen en to sta#ility $ay -resent a
greater risk to a #usiness than continual volatility"
In case o+ volatile -rices, a #usiness $ust #e structure to o-erate e++ectively
!ithin the volatile environ$ent"
Also, this situation $ay allo! -rice ata to #e accu$ulate, an e3-erience
!ith -rice -atterns to #e evelo-e"
This $ay -rovie in-ut to valuation $oels, an -rovie a #asis +or
structuring the #usiness o-eration"
=o!ever, in the case o+ -reviously sta#le conitions, the #usiness $ay #e
e3-ose to a negative i$-act, an there $ay #e little -receent to use +or
valuation $oels or +or -lanning"
In general, a #usiness shoul avoi $aking assu$-tions that -reviously
sta#le conitions !ill continue in the +uture"
2or e3a$-le, entering a long<ter$ +i3e<-rice contract, #ase on assu$-tions
that -ast conitions !ill continue, $ay create a risk +or a #usiness"
806
This -ossi#ility $ay #e aresse #y calculating $a3i$u$ risk e3-osures,
even in cases o+ sta#le -rices, an using risk $anage$ent $ethos such as
+or!ar sales an o-tions !hen e3-osures occur, even !hen -rices have
-reviously #een sta#le"
5.3.8.2. T.e aura$ of ris6 alulations
Risk calculations are #ase on a range o+ assu$-tions, an in ti$es o+
e3tre$e conitions, the actual loss $ay not re+lect the loss that !as e3-ecte
#ase on risk esti$ates an e3-erience"
This issue $ay #e aresse #y ensuring that the risk e3-osures are #ase on
calculations that $ay accurately re+lect conitions that $ay arise in e3tre$e
conitions, an #y ensuring that the risks are accurately assesse an
$anage"
2or e3a$-le, although statistical analysis can #e use in #anking an
insurance, in -ractice the stanars o+ creit assess$ent an uner!riting
$ay have a larger i$-act on losses that statistical $oels $ay suggest #ase
-urely on -ro#a#ilities"
Also, so$e co$-le3 instru$ents an heging -ort+olios $ay #e i++icult to
value, an risk e3-osure calculations at current levels $ay i++er +ro$ the
actual e3-osure uring crash conitions"
810
5.3.9. ,is6 alulation & tra(ing terms
A$erican style o-tion An o-tion that allo!s the o-tion to #e
e3ercise at any ti$e u- until the $aturity
ate" This is not relate to the location o+
o-tions traing, an A$erican<style o-tions
are trae in $any -laces an circu$stances"
Ask -rice An o++er to sell a +i3e &uantity o+ ite$s at a
s-eci+ie -rice in a #i<an<o++er $arket, also
kno!n si$-ly as an :o++er;"
Bi An o++er to #uy a certain volu$e o+ a
co$$oity at a certain -rice, loge in a #i<
an<o++er $arket such as a stock e3change"
Book A collection o+ risks, also kno!n as a
-ort+olio in the case o+ assets"
/all o-tion An o-tions contract !hich involves the right
to #uy a certain &uantity o+ a co$$oity, in
contrast to a -ut o-tion"
/lose out The act o+ cancelling an o-en +utures -osition
#y entering an o--osite -osition, !hich results
in the -osition #eing cancelle, an the current
-ro+it or loss #eing realise"
/overe -osition A -osition in !hich the #usiness currently
hols the -hysical co$$oity that !oul nee
to #e elivere into a risk instru$ent, such as
a +utures contract"
/rash test Re<valuing a -ort+olio assu$ing -rice changes
#ase on a $arket crash, to eter$ine the risk
e3-osure o+ the -ort+olio"
7erivative An instru$ent in !hich the -rice o+ the
instru$ent is #ase on the -rice o+ another
co$$oity" This inclues +utures an o-tions,
#ut not shares or #ons"
%uro-ean style o-tion An o-tion in !hich the o-tion can only #e
e3ercise on the e3-iry ate, in contrast to an
A$erican<style o-tion" The ter$ :%uro-ean;
oes not re+er to a location in this conte3t, an
%uro-ean<style o-tions are trae in $any
-laces an situations"
%3change<trae
instru$ent
An instru$ent that can #e #ought or sol
through an e3change such as a stock e3change
or a +utures e3change"
%3ercising an o-tion An action -er+or$e #y the holer o+ an
811
o-tion, to s-eci+ying that they !ish the o-tion
transaction to -rocee" Dhen this occurs, the
#uy or sell orer on !hich the o-tion is #ase
is conucte"
%3-osure =oling a traing -osition involving one or
$ore traa#le instru$ents, or having an
unerlying e3-osure to risk, such as holing a
-hysical co$$oity, or having a re&uire$ent
to -urchase or eliver co$$oities in the
+uture"
2or!ar A contract to #uy to sell a co$$oity at a
+uture ate at a +i3e -rice" An e&uivalent
e3change<trae instru$ent !oul #e a
+utures contract"
2utures contract A trae instru$ent that involves entering an
agree$ent to conuct a #uy or sell transaction
o+ a +i3e &uantity o+ a co$$oity at a +i3e
-rice on a +uture ate"
Instru$ent A contract, such as a +utures contract or an
o-tion contract"
,i&uiity The volu$e o+ traing that occurs in a
-articular instru$ent" ,o! li&uiity $ay lea
to i++iculty in entering an e3iting -ositions"
,ong -osition A -osition in !hich the #usiness !oul
#ene+it +ro$ an increase in -rice, such as
o!nershi- o+ an asset
Margin A -ay$ent loge !ith a #roker to $eet the
value o+ a loss<$aking -osition, to reuce the
creit risk o+ e+aults on +utures an o-tions
contracts"
Market $aker A -arty in a ealer $arket that :$akes a
$arket; #y &uoting a #uy an a sell -rice
!hen re&ueste to #y a client"
Moelling /reating a set o+ +or$ulas +or re-resenting the
value o+ an instru$ent or a -ort+olio, so that
the -rice an the risk e3-osures can #e
calculate"
Monte /arlo si$ulation A $etho o+ eter$ining the -rice an risk
e3-osures o+ risk instru$ents, #ase on
generating a large nu$#er o+ rano$ -rices,
an calculating the average result"
4ake -osition A -osition in !hich the #usiness oes not
currently hol the co$$oity that !oul nee
to #e elivere in to a risk instru$ent, such as
an o-tion or +utures contract"
812
A++er See :ask -rice;
A-tion A risk $anage$ent instru$ent that -rovies
the o-tion holer !ith the o-tion o+
conucting a #uy or sell transaction at a +i3e
-rice over a +i3e -erio o+ ti$e, or allo!ing
the o-tion to la-se !ith no transaction
occurring"
A-tion holer The -arty that #uys an o-tion, an has the
right to e3ercise the o-tion an inicate that
they !ish the o-tions transaction to -rocee
A-tion la-se I+ the o-tion holer takes no action #e+ore the
e3-iry ate o+ the o-tion, then no transaction
occurs, an the o-tion la-ses"
A-tion !riter The -arty that creates an o-tion, an $ust
eliver o+ acce-t the co$$oity i+ the o-tion
#uyer e3ercises the o-tion"
Aver<the<counter A transaction, such as an o-tion, entere
irectly !ith the counter-arty, !hich is
generally a #ank"
5osition =oling a current e3-osure to risk through an
instru$ent, such as entering a +utures contract,
#uying or !riting an o-tion, or a co$#ination
o+ se-arate -ositions"
5re$iu$ The -ay$ent $ae +or -urchasing an o-tion"
5ut o-tion An o-tions contract !hich involves the right
to sell a certain &uantity o+ a co$$oity, in
contrast to a call o-tion"
Risk In the conte3t o+ contracts an traa#le
instru$ents, a :risk; is a contract or situation
!hich $ay result in a -ro+it or loss occurring
+or the #usiness"
Risk 5ricing Hsing +or$ulas an si$ulations to eter$ine
the value o+ a risk instru$ent"
Short -osition A -osition in !hich a #usiness !oul #ene+it
+ro$ a +all in -rice, such as e3-osure to a ra!
$aterial -rice"
Strike -rice The -rice at !hich a #uy or sell transaction
!ill occur uner an o-tions contract, i+ the
o-tion is e3ercise"
S!a- A +inancial instru$ent in !hich one -arty
-ays a +i3e interest rate strea$ to the other
-arty, an receives a +loating interest rate
strea$ +ro$ the other -arty" The net
i++erence #et!een the t!o rates is -ai on
each interest -ay$ent ate"
813
'alue<at<risk A $etho o+ assessing risk, #ase on the loss
that !oul occur at a certain -ro#a#ility -rice
$ove$ent" (>>check etails)
Drite The act o+ creating an o-tion, in !hich case
the o-tion !riter receives the -ay$ent +ro$
selling the o-tion, an $ust eliver or acce-t
the o-tion co$$oity i+ the o-tion holer
e3ercises the o-tion"
810
#.". 2nsurance
Insurance $ay #e use in $any circu$stances in !hich an event $ay have a
negative i$-act on a #usiness"
Insurance generally involves a -ay$ent in avance, !ith a -ay$ent #eing
$ae to the #usiness i+ the insurance event occurs"
The a$ount o+ the -re$iu$ $ay #e #ase on the -ro#a#ility that the event
!ill occur, an the si@e o+ the -ay$ent"
This is kno!n as risk<#ase insurance"
Insurance in the co$$ercial conte3t is generally risk<#ase"
Ather ty-es o+ insurance arrange$ents are use so$e circu$stances, such as
in so$e health insurance syste$s"
In these situations, the -re$iu$s $ay not re+lect the risk o+ the event
occurring, an the sche$e $ay #e consiere to #e a savings sche$e in
certain res-ects, rather than an insurance sche$e"
5.4.1. 4nsurable events
A !ie range o+ events can #e insure"
This $ay inclue so$e o+ the +ollo!ing $a9or areas"
5.4.1.1. 3.$sial items
Ite$s o+ e&ui-$ent, #uilings, inventories o+ su--lies an co$-lete
$anu+acturing +acilities $ay all #e insure"
5ay$ents $ay #e $ae in the event o+ a$age, estruction or loss cause #y
a range o+ events, incluing +ire an the+t"
(eneral insurance +or -hysical ite$s is generally a cost<e++ective +or$ o+
insurance, !ith -ay$ents #eing #ase on the si@e an the -ro#a#ility o+ a
loss"
81*
5.4.1.2. 8egal ation
In so$e cases, insurance -olicies $ay #e use to $eet the -ay$ents that $ay
#eco$e ue as a result o+ legal action"
These -olicies generally cover s-eci+ic ty-es o+ legal action"
This !oul not inclue general legal action against the #usiness +or a #reach
o+ a contract"
Insurance can #e arrange +or so$e o+ the +ollo!ing ty-es o+ legal action"
5u#lic lia#ility ,egal action resulting to in9ury occurring to a
$e$#er o+ the -u#lic, such as a custo$er in9uring
the$selves !hile in the #usiness -re$ises"
5ro+essional ine$nity ,egal action relating to negligence in a -osition o+
legal res-onsi#ility such as a irector or a trustee"
The -re$iu$s o+ legal lia#ility insurance -olicies $ay #e large in so$e
cases, ue to the large -ay$ents that are so$eti$es eter$ine in legal
actions"
=o!ever, -ay$ents o+ these si@es are o+ten su++icient to lea to a -ersonal
#ankru-tcy or a $a9or loss to a #usiness"
Dhere they are a--lica#le, insurance -olicies o+ this ty-e $ay o+ten #e
consiere to #e a -re<re&uisite #e+ore any #usiness activity coul #e
consiere"
5.4.1.3. 4n%ur$
Insurance $ay #e availa#le to $eet -ay$ents +or $eical e3-enses, lost
inco$e an so +orth in the case o+ an in9ury occurring to an e$-loyee !hile
engage in activities relate to the #usiness o-eration"
This is a se-arate issue +ro$ a negligence legal action against the #usiness"
81)
In so$e situations, insurance o+ this ty-e, an -ossi#ly other +or$s o+
insurance, $ay #e re&uire #y co$$ercial regulations #e+ore a #usiness $ay
engage in #usiness o-erations"
5.4.1.4. Business ontinuit$ insurane
Business continuity insurance involves $aking -ay$ents to allo! the
#usiness o-eration to continue in the event o+ a $a9or -ro#le$ occurring
such as a +ire !ithin a $anu+acturing +acility"
The -ay$ents +ro$ a #usiness continuity -olicy $ay #e use to hire
te$-orary +acilities, -urchase su--lies o+ ra! $aterials, an so on"
This $ay continue +or a li$ite -erio o+ ti$e until the $ain +acilities !ere
reconstructe"
5.4.1.5. #peifi purpose
In the case o+ large transactions, s-eci+ic insurance arrange$ents can
so$eti$es #e $ae !ith an insurer to cover an iniviual event"
This $ay occur !hen the event can #e clearly e+ine, !here an esti$ate can
#e $ae o+ the -ro#a#ilities, an !here the risk is not e3cessively high"
As an e3a$-le, the launch o+ a co$$unications satellite $ay #e insure"
In this situation, a -re$iu$ $ay #e -ai to insure the event, an in the case
that the satellite !as estroye uring the launch or !as not success+ully
e-loye, a -ay$ent !oul #e $ae accoring to the -olicy arrange$ents"
As another e3a$-le, uner!riting arrange$ents are co$$only use in +loats
o+ co$-anies"
In these situations, i+ su#scri-tions +ro$ investors are not receive +or the +ull
set o+ shares, then an uner!riting arrange$ent $ay involve an invest$ent
#ank -urchasing the re$aining shares irectly +ro$ the co$-any"
818
5.4.1.!. #ummar$ of business insuranes
5hysical ite$s ,oss o+ or a$age to e&ui-$ent, #uilings,
$aterials stocks, $anu+acturing +acilities, an so
on"
,egal action 5ro+essional ine$nity" ,egal action relating to
negligence"
5u#lic lia#ility" ,egal action relating to -u#lic
in9ury"
In9ury DorkerCs co$-ensation relating to in9ury uring
#usiness activity"
Business continuity 5ay$ents in relation to continuing o-erations
uring te$-orary -ro#le$s such as a +acility
#eing a$age #y +ire"
S-eci+ic -ur-ose Any large event !hich can #e clearly e+ine, an
in !hich the -ro#a#ilities can #e esti$ate"
(>> in9uriesJlosses relating to -roucts, lia#ilityJinsurance etc)
5.4.2. -et.o(s of insurane
5.4.2.1. 7n(er5riting operations
Insurance $ay #e arrange through insurance co$-anies"
The -rocess o+ -roviing insurance an calculating -re$iu$s is kno!n as
uner!riting"
Insurance as a #usiness involves $aintaining a su$ o+ e&uity ca-ital, !hich
is use to $eet -ay$ents as they #eco$e ue"
5re$iu$s are collecte an -ay$ents are $ae"
811
A large nu$#er o+ se-arate risks $ay generally #e hel, !hich $ay lea to
the total value o+ assets, inco$e an -ay$ents #eing reasona#ly sta#le"
The large nu$#er o+ iniviual risks $ay result in an average return #eing
generate, rather than the large rise or +all in value that coul occur in the
case o+ a single risk"
5.4.2.2. #elf insurane
In the case o+ a large organisation, a sel+<insurance arrange$ent $ay
so$eti$es #e -ractical"
This $ay involve the #usiness #earing the risks irectly, rather than
arranging insurance !ith an e3ternal -arty"
0nfunded arrangements
In an un+une arrange$ent, the risk o+ loss is #orne irectly #y the cash
+lo! o+ the #usiness"
2or e3a$-le, a #usiness $ay have a large nu$#er o+ s$all ite$s o+ o++ice
e&ui-$ent in various locations"
Hner an insurance sche$e, the -re$iu$s -ai over the long ter$ $ay
a--ro3i$ately $atch the losses that $ay occur +ro$ ti$e to ti$e"
In situations such as these, insurance $ay not #e use, !ith the losses that
occur #eing recore as e3-enses !ithin the general revenue an e3-enses o+
the #usiness"
+unded arrangements
Alternatively, a :+une; arrange$ent $ay #e use"
In this case, a +i3e a$ount o+ $oney is allocate in each -erio, in a si$ilar
!ay to an insurance -re$iu$"
This $oney is then set asie in a se-arate +un, an use to $eet -ay$ents
that $ay #e necessary !hen losses occur"
816
The +un $ay #e a se-arate #ank account, although in $ost cases this !oul
#e an accounting entry !ithin the recors o+ the #usinessCs lia#ilities"
5.4.2.3. ,is6 instruments
In the case o+ so$e +inancial transactions, risk instru$ents coul #e use in
the conte3t o+ insuring against averse events"
2or e3a$-le, a :-ut; o-tion allo!s an asset to #e sol at a +i3e -rice +or a
-erio o+ ti$e, an this $ay insure the #usiness against the risk o+ a $arket
-rice +alling uring this ti$e"
Si$ilarly, a :call; o-tion coul #e use to ena#le the #usiness to -urchase
co$$oities at a +i3e -rice +or a -erio o+ ti$e, an so reuce the risk o+ a
loss arising +ro$ ra! $aterials rising in -rice"
A-tions $ay so$eti$es #e inclue in contracts !ith other -arties"
2or e3a$-le, a large -ro-erty evelo-$ent coul #e -urchase +ro$ a
evelo-er, an the contract $ay inclue a :-ut; o-tion that $ay allo! any
unsol units to #e sol #ack to the evelo-er at a reuce -rice, i+ #uyers
coul not #e +oun !ithin a s-eci+ie -erio o+ ti$e"
#.#. 5inance
2inance involves +uning #usiness activities, valuing assets, an valuing cash
+lo!s"
In -articular, +inance is concerne !ith calculations involving $oney"
2inancial calculations occur in $any areas o+ #usiness"
This inclues so$e o+ the +ollo!ing ite$s
Structures The structure o+ the #alance sheet, incluing e#t,
e&uity an asset values, the structure o+ the -ro+it
an loss state$ent, incluing inco$e, e3-enses,
net -ro+it an so on"
820
Margins Margins o+ net cash +lo! to sales, -ro+it $argins,
etc"
Ratios (earing ratios, return on assets, return on e&uity,
-rice to earnings ratios an so on"
Ti$e value o+ $oney /alculations involving loan -ay$ents, the -resent
value o+ +uture inco$e, -ro9ect cash +lo!s, an so
on"
Analysis o+ cash +lo!s +ro$ a #usiness -ers-ective $ay involve allocating
cash +lo!s to -erios o+ ti$e, such as $onthly -erios"
This $ay ena#le +igures such as inco$e, e3-enses an $argins to #e
calculate"
Analysis +ro$ a +inancial -ers-ective $ay involve consiering the ate on
!hich each cash +lo! occurs or is ue to occur"
This vie! $ay #e use in cases involving long ter$ cash +lo! structures,
such as loans an -ro9ects, an in situations !here large cash +lo!s occur
!ith s$all $argins"
5.5.1. T.e basis of finane
2inance is generally concerne !ith t!o issuesB asset values, an cash +lo!s"
Cash flows
A cash +lo! is e+ine #y the +ollo!ing three values
The si@e o+ the cash +lo!"
The sign o+ the cash +lo!, #eing either an in+lo! or an out+lo!"
The ate on !hich the cash +lo! occurs"
The si@e o+ a cash +lo! $ay #e a +i3e value, or it $ay #e an e3-ecte
average value #ase on a set o+ -ro#a#ilities"
821
In cases !here cash +lo!s occur on +i3e ates, all cash +lo! structures can
#e $oelling using this a--roach"
There is no re&uire$ent to istinguish #et!een :interest; an :-rinci-al;
-ay$ent on loans, +or e3a$-le, nor is it necessary to $aintain a conce-t o+ a
Uloan #alance;"
2or e3a$-le, in the case o+ cor-orate #ons, interest -ay$ents are kno!n as
:cou-on -ay$ents;, the -rinci-al re-ay$ent is kno!n as a :+ace value
ree$-tion;, an calculations involving cash +lo!s $ay not involve the ty-e
or -ur-ose o+ the cash +lo!"
=o!ever, the -rinci-al<an<interest $oel $ay #e a use+ul vie! +or certain
situations, such as the early ter$ination o+ a loan agree$ent"
2inancial calculations generally involve cash +lo!s occurring on +i3e ates"
In cases !here a cash +lo! coul occur at any ti$e !ithin a -erio, such as a
#uiling #eing estroye #y +ire an an insurance -ay$ent #eing $ae, a
$ore co$-le3 a--roach that the stanar ti$e<value<o+<$oney a--roach
$ay #e neee"
Asset values
An asset value is e+ine #y t!o -ara$eters"
These are the +ollo!ing t!o ite$s"
The value o+ the asset"
The ate on !hich the value a--lies"
The change in an asset value #et!een t!o ates is kno!n as a :return;"
alue transfers
A cash +lo! $ay involve a trans+er o+ actual cash"
822
In -ractice this !oul not generally involve currency such as coin an #ank
notes, #ut !oul involve a trans+er #et!een #ank accounts using a che&ue or
a irect trans+er"
In the +inance conte3t, the ter$ :cash; generally involves $oney hel in
#ank accounts, rather than -hysical currency"
A trans+er o+ value can also occur !hen other assets are trans+erre"
2or e3a$-le, the settle$ent o+ a -ro-erty -urchase $ay involve a cash
trans+er +ro$ the #uyer to the seller, an a value trans+er +ro$ the seller to the
#uyer, !hen the title o+ the -ro-erty is registere in the na$e o+ the #uyer"
'alue trans+ers that occur ue to in+lo!s or out+lo!s o+ assets can #e vie!e
in the sa$e !ay as cash +lo!s, an the sa$e calculations can #e use"
5.5.2. 3roperties of as. flo5s
2inancial calculations $ay generally consier a set o+ cash +lo!s occurring
on various ates"
,ndividual cash flows
Ane convention coul involve re-resenting cash in+lo!s as -ositive nu$#ers,
an re-resenting cash out+lo!s as negative nu$#ers"
/ash +lo!s o+ the sa$e si@e an sign, an occurring on the sa$e ate, are
e&uivalent"
Separation of cash flows
/ash +lo!s that occur on the sa$e ate can #e ae an su#tracte to
eter$ine the total net cash +lo!"
Also, !hen a transaction involves several cash +lo!s, each cash +lo! can #e
consiere se-arately"
2or e3a$-le, a #on $ay involve a series o+ interest -ay$ents"
The initial value o+ the #on can #e eter$ine #y converting each iniviual
-ay$ent to an e&uivalent -ay$ent on the co$$ence$ent ate, an su$$ing
823
the -resent values o+ each iniviual -ay$ent to eter$ine the total #on
value"
Cash flows on different dates
/ash +lo!s o+ the sa$e si@e that occur on i++erent ates are not e&uivalent"
In these cases, irectly aing an su#tracting cash +lo!s oes not
eter$ine the e++ective net value o+ the cash +lo!s"
This can #e eter$ine #y converting each cash +lo! to an e&uivalent value
on the sa$e ate, #e+ore the values are ae or su#tracte"
0ncertain cash flows
In so$e cases, the si@e o+ a cash +lo! $ay #e unkno!n, an $ay #e #ase on
a set o+ -ossi#le values an -ro#a#ilities"
In these cases, the cash +lo! can #e converte to an e&uivalent e++ective
value #y calculating the !eighte average value o+ the set o+ -ossi#le values,
#e+ore any other +inancial calculations are -er+or$e"
Asset values
The $arket value o+ an asset can #e consiere to #e a -otential cash +lo!"
In other !ors, the $arket value o+ an asset $ay #e the si@e o+ the cash +lo!
that coul #e generate i+ the asset !as #ought or sol"
/alculations involving asset values $ay #e -er+or$e using the sa$e
a--roach as calculations involving actual cash +lo!s"
Accounting
Accounting involves irectly aing cash +lo!s that occur !ithin a -erio to
eter$ine a total value +or the -erio"
This is a -ractical a--roach in $any circu$stances"
820
=o!ever, !hile this a--roach can #e use to eter$ine the total ollar
a$ount o+ a set o+ -ay$ents, it is not strictly vali as an a--roach to
eter$ine the total e++ective value o+ the -ay$ents that $ay #e involve"
5.5.3. +onventions
The +or$ulas in this section use varia#les in the +ollo!ing +or$ats
aria"le alue
y The interest rate -er -erio, in eci$al +or$at
n The total nu$#er o+ -erios
a$ount The value o+ a single cash +lo!
-ay$ent Thr -ay$ent a$ount -er -erio
-resent value The value on the current ate, or an early ate
+uture value The value at a +uture ate
In the case o+ $onthly calculations, the +ollo!ing +or$ulas !oul a--ly
1200
rate erest int percentage annual
y
12 years of number n
5.5.4. +onversions
Interest rate +igures can #e converte using the +ollo!ing e&uations"
100
rate percentage
rate decimal
82*
100 rate decimal rate percentage
All calculations are -er+or$e using a nu$#er o+ co$-ouning -erios,
rather than a nu$#er o+ years"
2or e3a$-le, the interest rate +or one -erio can #e calculate using the
+ollo!ing e&uation"
year per periods
rate annual
period per rate
The nu$#er o+ -erios can #e calculate using the +ollo!ing +or$ula"
years of number year per periods periods of number
2or e3a$-le, a loan $ay involve an annual interest rate o+ 1L, !ith $onthly
-ay$ents over a +ive year ter$"
The +ollo!ing ste-s coul #e taken #e+ore any loan calculations !ere
-er+or$e"
100
rate erest int percentage
rate erest int decimal
100
1

01 0.
12
rate erest int annual
period per rate
82)
12
01 0.

00)))8 0.
years of number year per periods periods of number
* 12
)0
Annual figures
Annual +igures can #e eter$ine +ro$ -er<-erio +igures using the
+ollo!ing +or$ulas"
payment year per periods payment annual
year per periods period per rate rate annual
(%ponentiation
The :e3-onentiation; o-eration involves raising one nu$#er to the -o!er o+
another nu$#er"
This is re-resente in the +or$ y
3
"
This o-eration involves the value :y; #eing $ulti-lie #y itsel+ :3; ti$es"
2or e3a$-le, 3
*
is e&ual to 3 3 3 3 3 3 3 3 3, !hich is 203"
This +unction $ay #e availa#le on calculators that inclue scienti+ic or
+inancial calculations, an !ithin co$-uter so+t!are such as s-reasheet
-rogra$s"
828
5.5.5. T.e time value of mone$
The e++ective value o+ a cash +lo! is e-enant on the ate on !hich it
occurs"
2or e3a$-le, an a$ount o+ G100 that is receive toay is not e&uivalent to an
a$ount o+ G100 that is receive in one yearCs ti$e"
At an interest rate o+ 1L, the a$ount that is receive toay coul #e investe,
an $ay gro! to a value o+ G101 at the en o+ the year"
At this ti$e, the +irst -ay$ent !oul #e !orth G101, ho!ever the alternative
-ay$ent !oul only #e !orth G100"
This illustrates that the t!o -ay$ents are not e&uivalent, as they occur on
i++erent ates"
This -rinci-le is kno!n as the :ti$e value o+ $oney;"
A cash +lo! that occurs on one ate can #e converte to an e&uivalent value
on any other ate #y using a ti$e<value<o+<$oney calculation"
5.5.5.1. 3resent values
A -resent value calculation involves converting a +uture -ay$ent to an
e&uivalent value on an earlier ate"
In the case o+ a single -erio, the +ollo!ing +or$ula can #e use to calculate
the -resent value o+ a +uture -ay$ent"
rate erest int
value future
value present
+

1
This is the +una$ental relationshi- o+ the ti$e value o+ $oney"
All ti$e<value calculations, no $atter ho! co$-le3, are #ase on this
relationshi-"
821
In the case o+ a ti$e +ra$e covering several -erios, the +ollo!ing +or$ula
can #e use
( )
n
y
amount
value present
+

1
As interest -ay$ents are not involve, the ter$ :iscount rate; $ay #e use
+or the rate that is use in the calculation, rather than the ter$ :interest rate;"
As an e3a$-le, an a$ount o+ G100 $ay #e ue to #e receive in +ive years
ti$e"
Assu$ing a iscount rate o+ 10L, the -resent value o+ this a$ount coul #e
calculate using the +ollo!ing e3a$-le"
( )
*
1 0 1
100
.
value present
+

*
1 1
100
.

)10* 1
100
.

)2 5
This e3a$-le illustrates that a -ay$ent o+ G100 that !as ue to #e receive
in +ive years !oul #e e&uivalent to a -ay$ent o+ G)2 that !as receive
i$$eiately"
This e3a$-le assu$es that co$-ouning occurs annually, !ith interest #eing
-ai an re<investe each year"
5.5.5.2. /uture values
826
A +uture value involves eter$ining the e++ective value o+ a cash +lo! on a
+uture ate"
The +or$ula use is the sa$e +or$ula that is use to calculate a -resent
value, ho!ever the +or$ula is re<arrange to calculate the +uture a$ount
rather than the earlier a$ount"
2or e3a$-le, the +ollo!ing +or$ula coul #e use to calculate a +uture value"
( )
n
y amount value future + 1
2or e3a$-le, an a$ount o+ G20 $ay #e -lace on e-osit at an interest rate
o+ 8L"
As the en o+ a +ive year -erio, the e&uivalent value coul #e eter$ine
+ro$ the +ollo!ing e3a$-le
( )
*
08 0 1 20 . value future +
21 5
The sa$e calculations $ay #e use !hether interest is actually receive, or
!hether a cash +lo! on one ate is si$-ly converte to an e&uivalent value
on a i++erent ate"
5.5.5.3. 3artial perio(s
In cases !here the ti$e -erio oes not e3actly $atch a !hole nu$#er o+
-erios, the +ollo!ing a9ust$ents can #e $ae to the stanar +or$ulas"
Less than one period
I+ the length o+ ti$e is less than a +ull -erio, the +ollo!ing +or$ulas can #e
use
830

,
_

y
period in days
days
amount
value present
1

,
_

+ y
period in days
days
amount value future 1
2or e3a$-le, an a$ount o+ G20 $ay #e ue in si3 $onthCs ti$e"
Assu$ing an annual interest rate o+ 8L, the -resent value coul #e calculate
using the +ollo!ing e3a$-le
A$ount 20
7ays 112 () $onths)
7ays<in<-erio 3)*
7eci$al interest rate 0"08

,
_

08 0
3)*
112
1
20
.
value
33 16. 5
/ultiple periods
In cases !here a ti$e -erio is greater than a single -erio, #ut is not e3actly
e&ual to a !hole nu$#er o+ -erios, the +ollo!ing +or$ulas can #e use
( )
period in days
days
y
amount
value present
+

1
( )
period in days
days
y amount value future + 1
831
2or e3a$-le, a si$ilar a$ount to the -revious e3a$-le $ay #e ue in
eighteen $onths ti$e"
In this case, the -resent value coul #e calculate using the +ollo!ing
e3a$-le"
*01 * 1 3)* . days
( )
3)*
*01
08 0 1
20
.
value present
+

( )
*010 1
08 0 1
20
.
. +

08 11. 5
In cases !here the ti$e -erio e3actly $atches a !hole nu$#er o+ -erios,
these +or$ulas #eco$e the stanar -resent value an +uture value +or$ulas"
5.5.5.4. 'nnuities
An :annuity; is a series o+ regular -ay$ents"
2or e3a$-le, the interest -ay$ents o+ a #on, the re-ay$ents o+ a loan, an a
strea$ o+ +uture inco$e cash +lo!s, are all e3a$-les o+ annuities"
5.5.5.4.1. T.e present value of an annuit$
The -resent value o+ a set o+ annuity -ay$ents can #e calculate #y
calculating the -resent value o+ each -ay$ent se-arately, an su$$ing the
a$ounts to eter$ine a total -resent value +or all the -ay$ents on a certain
ate"
832
=o!ever, in the case o+ a series o+ -ay$ents o+ the sa$e si@e an ti$ing, the
+ollo!ing +or$ula can also #e use to calculate the -resent value o+ the
-ay$ents"
( )
y
y
payment value present
n
+

1 1
The +ollo!ing conitions a--ly to this +or$ula"
5ay$ents The +irst -ay$ent occurs at the en o+ the +irst
-erio, the nu$#er o+ -ay$ents is e&ual to the
nu$#er o+ -erios, an the last -ay$ent occurs at
the en o+ the last -erio"
/o$-ouning /o$-ouning occurs !ith each -erio"
2or e3a$-le, a #on $ay involve interest -ay$ents o+ G* each si3 $onths,
+or a total -erio o+ +ive years"
Assu$ing an interest rate o+ 1L, the total -resent value o+ these -ay$ents
coul #e calculate using the +ollo!ing e3a$-le
year per periods
rate annual
period per rate
12
01 0.

00)))8 0.
( )
y
y
payment value present
n
+

1 1
833
( )
00)))8 0
00)))8 0 1 1
*
)0
.
.

+

** 00. 5
This e3a$-le illustrates that the -ay$ents o+ G* every si3 $onths +or +ive
years !oul #e e&uivalent to a single a$ount o+ G00"** that is -ai
i$$eiately, assu$ing a iscount rate o+ 1L +or the +uture -ay$ents"
At the en o+ the +ive year -erio, the -rinci-al value o+ the #on $ay #e
re-ai"
In the case o+ a +ace value o+ G100, the +ace value coul #e converte to an
e&uivalent -resent value using the -resent value +or$ula"
2or e3a$-le, the +ollo!ing calculation $ay a--ly"
( )
*
01 0 1
100
.
value
+

0) )1. 5
The total value o+ the #on !oul then #e e&ual to the total -resent values o+
the interest -ay$ents an the -rinci-al -ay$ent"
This coul #e calculate using the +ollo!ing e3a$-le"
0) )1 ** 00 . . value bond +
)1 101. 5
5.5.5.4.2. T.e future value of an annuit$
The +uture value o+ an annuity can #e calculate using the +ollo!ing +or$ula
830
( )
y
y
payment value future
n
1 1 +

This +or$ula is #ase on the sa$e set o+ conitions as the -resent value
+or$ula"
2or e3a$-le, an a$ount o+ G10 $ay #e e-osite each $onth +or a -erio o+
three years, !ith an annual interest rate o+ 1L #eing -ai on a $onthly #asis"
The +uture value at the en o+ the three year -erio coul #e calculate using
the +ollo!ing e3a$-le
00))8 0
1200
1
. rate erest int
( )
y
y
payment value future
n
1 1 +

( )
00)))8 0
1 00)))8 0 1
10
3)
.
. +

00* 5
5.5.5.4.3. 1ro5t. annuities
In so$e situations, the -ay$ents $ay not #e constant, #ut $ay gro! at a
certain rate"
2or e3a$-le, the inco$e +ro$ a -ro9ect $ay #e -ro9ecte over a -erio o+ ten
years"
The inco$e $ay #e esti$ate at G30 -er year in the +irst year, gro!ing at *L
each year in line !ithin in+lation"
In the case o+ gro!ing annuity -ay$ents, the +ollo!ing +or$ulas can #e use
in -lace o+ the stanar annuity +or$ulas"
83*
( )
( )
1
1
]
1

+
+

+
g
y
g
y g
payment
value present
n
n
1
1
1
1
( ) ( ) ( ) [ ]
n n
9 y 7 g g
y g
amount
value future + + +

1 1 1
In these +or$ulas, the varia#le :g; is the gro!th rate o+ the -ay$ents -er
-erio, in eci$al +or$at"
These +or$ulas a--ly in cases !here the gro!th rate $ay #e higher or lo!er
than the iscount rate"
In situations !here the gro!th rate is e&ual to the iscount rate, the +ollo!ing
+or$ulas $ay #e use"
n payment value present
( )
n
y n payment value future + 1
5.5.5.4.4. 3erpetual annuities
5er-etual annuities involve -ay$ents that continue +orever"
2or e3a$-le, in the year (>> check year), the British govern$ent issue a
nu$#er o+ #ons kno!n as :consols;"
These #ons -ai interest at a rate o+ (>>check), !ith interest -ay$ents to
continue on a si3<$onthly #asis +orever"
Several hunre years later, interest -ay$ents are still $ae on these #ons,
an a s$all nu$#er o+ consols are still trae in ,onon ca-ital $arkets"
5er-etual annuity calculations can #e use in a range o+ circu$stances"
83)
2or e3a$-le, #ank e-osits an shares are e++ectively -er-etual invest$ents,
as the interest or ivien -ay$ents o not occur +or a li$ite -erio o+ ti$e,
an in theory coul continue +orever unless circu$stances change"
Also, -ay$ents that occur on very istant ates $ay have very s$all -resent
values"
In the case o+ so$e long<ter$ invest$ents, a -er-etual annuity calculation
$ay #e use to -rovie an a--ro3i$ate value, ignoring the +act that the
-ay$ents $ay cease at a istant ti$e"
The -resent value o+ a -er-etual annuity can #e calculate using the
+ollo!ing +or$ula"
y
payment
value present
2or e3a$-le, an annuity inco$e strea$, such as rental inco$e, $ay involve
-ay$ents o+ G30 -er year"
Assu$ing a iscount rate o+ 1L, the -resent value o+ these -ay$ents coul
#e calculate using the +ollo!ing e3a$-le"
01 0
30
.
value present
38* 5
In cases !here the -ay$ents increase as ti$e -asses, the +ollo!ing +or$ula
can #e use"
g y
amount
value present

838
In this +or$ula, :y; is the iscount rate, an :g; is the rate o+ increase in the
-ay$ents"
This +or$ula a--lies !hen the gro!th rate is less than the iscount rate"
Dhen the gro!th rate is e&ual to the iscount rate, or higher than the iscount
rate, then the value o+ a gro!ing -er-etual annuity is in+inite"
5.5.5.5. =et 3resent :alue
In the case o+ a co$-le3 set o+ cash +lo!s, such as a #on, or the cash +lo!s
+ro$ a -ro9ect, the -resent value o+ each iniviual -ay$ent can #e su$$e
on a single ate, to eter$ine a total value +or the set o+ cash +lo!s"
This is kno!n as a :net -resent value; calculation"
4et -resent values are use to value -ro9ects, #usinesses, +inancial
instru$ents, -ro-erties, an any situation !here a series o+ +uture cash +lo!s
$ay occur"
2or e3a$-le, a -ro9ect $ay involve a cost o+ G10 -er year +or three years,
+ollo!e #y inco$e o+ G*0 -er year +or +i+teen years"
Assu$ing a iscount rate o+ 12L, the inco$e strea$ coul #e reuce to an
e++ective value at the three<year -oint #y using the annuity +or$ula"
2or e3a$-le, the +ollo!ing calculation coul #e use
( )
y
y
payment value
n
+

1 1
( )
12 0
12 0 1 1
*0
1*
.
.

+

300 5
This value re-resents the value o+ the inco$e annuity strea$ at the
co$$ence$ent o+ the inco$e, !hich $ay occur at the three<year -oint in the
-ro9ect"
831
This +igure coul then #e reuce to a -resent value at the #eginning o+ the
-ro9ect, using the -resent value +or$ula"
2or e3a$-le, the +ollo!ing calculation $ay a--ly"
( )
3
12 0 1
300
.
value present
+

202 5
This value re-resents the -resent value, at the co$$ence$ent o+ the -ro9ect,
o+ the +uture inco$e strea$"
The -resent value o+ the costs coul #e calculate using the annuity +or$ula"
The +ollo!ing calculation $ay a--ly in this case"
( )
y
y
payment value
n
+

1 1
( )
12 0
12 0 1 1
10
3
.
.

+

162 5
The total value o+ the -ro9ect coul then #e calculate +ro$ su$$ing the
-resent values o+ all the cash +lo!s, incluing the cash in+lo!s an the cash
out+lo!s"
2or e3a$-le
162 202 value present net
836
*0 5
Ma9or issues in -er+or$ing a net -resent value calculation $ay inclue
esti$ating the -ossi#le +uture cash +lo!s, an selecting a iscount rate to
a--ly to the calculation"
4et -resent value calculations are also kno!n as :iscounte cash +lo!;
calculations"
5.5.5.!. 4nternal ,ate of ,eturn
In so$e cases, a co$-lete set o+ cash +lo!s $ay #e kno!n"
In these situations, the e++ective iscount rate that a--lies to the set o+ cash
+lo!s $ay #e eter$ine"
This is kno!n as an :internal rate o+ return; calculation"
2or e3a$-le, the cash in+lo! o+ a loan, an the cash out+lo!s o+ the
re-ay$ents, coul #e #alance to a net -resent value o+ @ero, to eter$ine the
interest rate that !as e$#ee !ithin the loan structure"
The IRR is calculate #y eter$ining the iscount rate than leas to the net
-resent value o+ the set o+ cash +lo!s #eing e&ual to @ero"
To calculate an internal rate o+ return, there $ust #e at least one -ositive cash
+lo! an one negative cash +lo!"
In the case o+ -urchasing an invest$ent, an initial negative cash +lo! $ay
re-resent the -urchase -rice, !hile a series o+ -ositive cash +lo!s $ay
re-resent inco$e +ro$ the invest$ent or +ro$ increases in value"
The IRR cannot generally #e calculate irectly using a +or$ula"
The net<-resent<value a--roach $ust #e use, an a iscount rate $ust #e
eter$ine that results in the net -resent value #eing a--ro3i$ately e&ual to
@ero"
This can #e one using a trial<an<error a--roach, selecting various iscount
rates, or #y using co$-uter so+t!are such as a s-reasheet -rogra$, that
inclues a goal<seeking +unction"
800
2or e3a$-le, a #on $ay #e availa#le +or -urchase at a -rice o+ G106"
The #on $ay inclue interest -ay$ents o+ G* each si3 $onths +or +ive years,
+ollo!e #y a -rinci-al re-ay$ent o+ G100"
The net value o+ the transaction !oul #e e&ual to the -resent value o+ the
inco$e an the -rinci-al -ay$ents, $inus the -urchase -rice o+ the #on"
Selecting a iscount rate that results in this total e&ualling @ero, leas to a
+igure o+ 8"1L
This is the IRR o+ the #on -urchase, at a -urchase -rice o+ G106"
In other ter$s, -urchasing the #on at this -rice !oul relate to an
invest$ent return o+ 8"6L"
=o!ever, as each -ay$ent occurs at a i++erent -oint in ti$e, this !oul only
#e e&uivalent to investing the entire a$ount at a rate o+ 8"6L i+ the early
-ay$ents coul #e re<investe at this rate"
/ultiple ,$$ figures
The IRR a--roach can #e use to eter$ine an e++ective return +ro$
investing in a -ro9ect that $ay involve a set o+ cash in+lo!s an cash
out+lo!s"
In the case o+ invest$ents !ith one cash out+lo! an then a series o+ cash
in+lo!s, only one IRR value is -ossi#le
This value coul #e consiere to #e the invest$ent return"
=o!ever, in so$e cases, $ore than one -ossi#le value +or the IRR $ay e3ist"
Dhen the cash +lo!s change +ro$ a -ositive value to a negative value $ore
than once uring the total -erio, the nu$#er o+ -ossi#le IRR +igures $ay #e
e&ual to the nu$#er o+ ti$es that the cash +lo!s change sign"
In these cases, each +igure $ay #e $athe$atically vali, an the IRR
a--roach $ay have li$ite -ractical a--lication as an inication o+ an
invest$ent return"
3urdle rates
801
Situations such as these are so$eti$es aresse #y selecting a :hurle rate;
+or invest$ent -ro9ects"
The hurle rate is chosen as a target or $ini$u$ rate o+ return +ro$ a
-ro9ect"
In so$e cases, the hurle rate is eter$ine +ro$ the !eighte average cost
o+ ca-ital o+ the organisation"
In theory, investing in -ro9ects that involve a higher return than the cost o+
ca-ital $ay result in a -ro+ita#le invest$ent"
In other cases, a range o+ i++erent -ro9ect alternatives $ay #e availa#le"
In this situation, a hurle rate $ay #e chosen so that su++icient -ro9ects !ere
selecte to ena#le the availa#le ca-ital to #e +ully investe"
The hurle rate is use as a iscount rate in a net -resent value calculation"
A -ositive 45' +igure, calculate using the hurle rate, $ay suggest that the
rate o+ return +ro$ the -ro9ect $ay e3cee the hurle rate"
,nvestment returns
The internal rate o+ return o+ a #on is kno!n as the #onCs :yiel to
$aturity;"
In the case o+ a single cash in+lo! an a single out+lo!, the internal rate o+
return is e&ual to the invest$ent return o+ the cash +lo!s"
In the case o+ a $ore co$-le3 set o+ cash +lo!s, the IRR can also #e
consiere an invest$ent return"
=o!ever, this !oul only lea to an actual invest$ent return in a case !here
early -ay$ents coul #e re<investe at the sa$e rate as the IRR"
In so$e situations, a single cash out+lo! $ay #e +ollo!e #y several cash
in+lo!s, such as in the case o+ a #on"
In this case, the initial -ay$ent coul #e vie!e as a co$#ination o+ several
se-arate invest$ents over i++erent ti$e +ra$es, corres-oning to each cash
in+lo!"
802
Dhile the IRR $ay #e a use+ul $easure o+ an invest$ent return, it $ay not
$atch the return o+ investing an initial su$ over a single -erio o+ ti$e"
5.5.5.7. 4nterest
The interest ue on a loan or a e-osit can #e calculate using the +ollo!ing
+or$ula
3)* 100
days of number rate erest int percentage annual
amount erest int
In the case o+ $onthly calculations, the nu$#er o+ $onths ivie #y 12
coul #e use, rather than the nu$#er o+ ays ivie #y 3)*"
2or e3a$-le, a loan o+ G00 $ay have interest -aya#le $onthly, at an annual
interest rate o+ 6L"
The interest +or a $onth coul #e calculate using the +ollo!ing e3a$-le
3)*
31
100
6
00 erest int
31 0. 5
5.5.5.8. #peifi situations
The +una$ental +inancial relationshi- o+ the -resent value o+ a cash +lo!
can #e use to eter$ine the e++ective values o+ cash +lo!s in any situation,
no $atter ho! co$-le3"
A nu$#er o+ s-eci+ic situations $ay inclue so$e o+ the +ollo!ing ite$s"
5.5.5.8.1. 'mortising loans.
803
An a$ortising loan involves -ay$ents that are larger than the initial interest
-ay$ent"
A$ortising loans can #e vie!e in t!o !ays"
Ane -ers-ective involves a :loan #alance;, !hich reuces to @ero over the
ter$ o+ the loan, !ith loan -ay$ents covering #oth interest an -rinci-al
a$ounts"
An alternative -ers-ective involves a cash in+lo! +ollo!e #y a series o+ cash
out+lo!s"
In this vie!, there is no se-aration #et!een :interest; -ay$ents an
:-rinci-al; -ay$ents, an there is no conce-t o+ a current :loan #alance;"
The loan structure si$-ly involves a series o+ -ositive an negative cash
+lo!s"
This is the vie! that $ay generally #e use in +inancial calculations"
Both vie!s are -ers-ectives on the sa$e set o+ cash +lo!s"
The loan<#alance vie! $ay #e use+ul in revie!ing the -ay$ent that !oul #e
involve in ter$inating a loan arrange$ent #e+ore the en o+ the -erio"
Alternatively, the cash +lo! structure -ers-ective $ay allo! cash +lo!s o+
ar#itrary co$-le3ity to #e si$-ly $oelle"
The re-ay$ents ue on an a$ortising loan can #e calculate using the
annuity +or$ula"
The can #e rearrange into the +ollo!ing +or$at"
( )
n
y
y
value loan payment

+

1 1
2or e3a$-le, a loan !ith a value o+ G100 $ay have a ter$ o+ 10 years an an
interest rate o+ 6L"
Assu$ing $onthly re-ay$ents, the re-ay$ent a$ount on this loan coul #e
calculate using the +ollo!ing e3a$-le"
800
008* 0
1200
6
. rate erest int
( )
120
008* 0 1 1
008* 0
100

+

.
.
payment
28 1. 5
5.5.5.8.2. #in6ing fun(s
In so$e situations, -erioic -ay$ents $ay #e $ae into a +un !ith the ai$
o+ accu$ulating a su$ o+ $oney"
2or e3a$-le, a $achine $ay #e -urchase !ith an e3-ecte o-erating
li+eti$e o+ eight years"
Monthly -ay$ents $ay #e $ae into an account to accu$ulate a lu$- su$
at the en o+ the eight year -erio, to ena#le a re-lace$ent $achine to #e
-urchase"
This is kno!n as a :sinking +un;"
A sinking +un $ay involve a se-arate #ank account, although in $ost cases
this !oul si$-ly #e an accounting entry in the recors o+ the lia#ilities o+
the #usiness"
The -ay$ents that are re&uire +or a sinking +un can #e eter$ine using
the annuity +or$ula"
As a +irst ste-, the +inal value $ay nee to #e calculate"
2or e3a$-le, the $achine $ay have a value o+ G100"
Assu$ing an in+lation rate o+ *L, the a$ount that !oul #e re&uire to
re-lace the $achine at the en o+ the eight year -erio coul #e calculate
using the +uture value +or$ula"
2or e3a$-le, in this case the +ollo!ing calculation $ay a--ly"
80*
( )
n
y amount value future + 1
( )
1
0* 0 1 100 . +
108 5
This inicates that an a$ount o+ G108 !oul #e neee in eight yearCs ti$e
to re-lace the $achine, assu$ing an in+lation rate o+ *L"
The -ay$ents coul then #e calculate using the +ollo!ing +or$ula"
( )
n
y
y
amount payment

+

1 1
2or e3a$-le, assu$ing that an interest rate o+ 8L !as availa#le an that
$onthly -ay$ents !ere $ae, the +ollo!ing calculation $ay #e use"
00*133 0
1200
8
. rate erest int
6)
00*133 0 1 1
00*133 0
108

+

9 . 7
.
payment
00 2. 5
This calculation suggests that -ay$ents o+ G2"00 -er $onth !oul nee to #e
$ae into an account earning 8L interest, in orer to accu$ulate a value o+
G108 in eight yearCs ti$e"
5.5.5.8.3. Embe((e( interest rates
80)
In so$e cases, the -ay$ents o+ a loan structure $ay #e kno!n, ho!ever the
interest rate $ay #e unkno!n"
2or e3a$-le, an ite$ o+ e&ui-$ent $ay #e availa#le +or -urchase in a single
-ay$ent, or through a series o+ instal$ents"
In a situation such as this, the interest rate that is inclue !ithin the -ay$ent
structure $ay #e calculate"
In orer to -er+or$ this calculation, the e&uivalent value o+ the transaction as
a single lu$- su$ $ust #e kno!n"
This $ay #e availa#le as a se-arate &uote -rice +or an i$$eiate -urchase,
or in other cases the value o+ the ite$ coul #e esti$ate +ro$ the sale -rice
o+ si$ilar ite$s"
The interest rate that is inclue !ithin a -ay$ent structure can #e calculate
using an internal<rate<o+<return calculation"
This $ay involve calculating the -resent value o+ the -ay$ents, using the
annuity +or$ula, or calculating the -resent value o+ each iniviual -ay$ent"
7iscount rates $ay then #y altere using trial<an<error, or using a goal<
seeking +unction such as a s-reasheet -rogra$, until a rate is +oun that sets
the -resent value o+ the -ay$ents to e&ual the +i3e initial lu$- su$
-ay$ent"
2or e3a$-le, a $achine $ay #e availa#le +or i$$eiate -urchase +or G100,
on through $onthly -ay$ents o+ G3"20 +or three years"
The -resent value o+ the -ay$ents coul #e calculate using the annuity
+or$ula, as liste #elo!
( )
y
y
. value
3)
1 1
20 3

+

Altering the value o+ :y; until the -resent value e&ualle the lu$-<su$ -rice
o+ G100, leas to a +igure o+ 0"0081) +or the $onthly interest rate"
Multi-lying #y t!elve, this i$-lies an annual interest rate o+ 6"0L"
808
5.5.5.8.4. 4nome streams
In so$e cases, a large -ay$ent $ay #e $ae as a cash out+lo!, an a series
o+ regular inco$e -ay$ents $ay occur over a -erio o+ ti$e, involving cash
in+lo!s"
This $ay a--ly in the case o+ investing in evelo-ing a ne! -rouct or
+acility, +or e3a$-le"
Also, this situation $ay a--ly to -urchasing a large ite$ o+ ca-ital
e&ui-$ent, !ith a regular series o+ inco$e -ay$ents occurring +ro$
charging +ees +or the use o+ the e&ui-$ent"
As an e3a$-le, a $achine $ay #e availa#le +or -urchase at a cost o+ G80
The e3-ecte inco$e $ay #e G10 -er year over a +i+teen year li+e o+ the
$achine"
In this situation, the internal rate o+ return o+ the cash +lo!s coul #e
calculate, #y eter$ining the iscount rate that resulte in the annuity
+or$ula e&ualling the -urchase cost o+ G80
This internal rate o+ return coul #e use as a $easure o+ the invest$ent
return involve in -urchasing the $achine"
Alternatively, a iscount rate coul #e chosen"
2or e3a$-le, a iscount rate o+ 1*L $ay #e chosen, consiering the level o+
current interest rates an the risk involve in the -ro9ect"
The -resent value o+ the inco$e strea$ coul then #e calculate using
annuity +or$ula"
2or e3a$-le
( )
1* 0
1* 0 1 1
10
1*
.
.
value

+

8) 5
As the -resent value o+ the inco$e strea$ is higher than the cost o+ the
$achine, this $ay re-resent a !orth!hile invest$ent"
801
The cost o+ the $achine coul also #e ae as a cash +lo! to eter$ine the
total net<-resent<value o+ the cash +lo!s
80 8) value present net
) +
5.5.!. :ariable returns
In so$e cases, the rate o+ return that $ay a--ly $ay i++er +ro$ one -erio to
the ne3t"
The ter$ :return; is o+ten use in the case o+ changing assets values, !hile
:interest rate; or :iscount rate; $ay #e use in the case o+ cash +lo!s"
=o!ever, the sa$e conce-t a--lies, an the sa$e calculations $ay #e
involve in each case"
7i++erent returns $ay a--ly in each -erio in the case o+ invest$ent returns,
changing asset values, an :+or!ar rates;, !here a i++erent interest rate
a--lies in each +uture -erio"
In these cases, the total return over a -erio can #e calculate using the
+ollo!ing +or$ula"
( ) together multiplied period each for rate erest int return total + 1
2or e3a$-le, the return +igures o+ 10L, 3L an *L $ay a--ly +or three
-erios"
In this e3a$-le, the total return coul #e calculate in the +ollo!ing !ay"
( ) ( ) ( ) 1 0* 0 1 03 0 1 1 0 1 + + + . . . return total
.0 16
806
This +or$ula can #e e3-resse in the +uture value +or$, using the +ollo!ing
+or$ula
( ) period each for rate erest int by multiplied amount value future + 1
2or e3a$-le, an a$ount o+ G100 $ay have interest rates o+ 0L, 2L an 3L
a--lying to it +or three consecutive -erios"
The +uture value o+ this a$ount coul #e calculate using the +ollo!ing
e3a$-le"
( ) ( ) ( ) 03 0 1 02 0 1 00 0 1 100 . . . value future + + +
2) 106.
In the case that all the returns or interest rates are the sa$e, this +or$ula
#eco$es the stanar +uture value +or$ula"
Average returns
An average return coul #e calculate using the stanar arith$etic average
o+ the iniviual returns"
=o!ever, ue to the +act that the returns are $ulti-lie, not ae, the
arith$etic average $ay not e&ual the return that !oul a--ly to each single
-erio"
In other ter$s, using the arith$etic average return +or each -erio $ay not
-rouce the sa$e result as using the iniviual returns"
2or this reason, a $ore accurate $easure o+ an average return $ay #e the
:geo$etric average; return"
This can #e calculate using the +ollo!ing +or$ula
(eo$etric average P (1 M interest rate) $ulti-lie together, raise to
the -o!er o+ (1 J nu$#er o+ -erios)
8*0
2or e3a$-le, in the -revious case o+ the returns o+ 10L, 3L an *L, the
geo$etric average coul #e calculate using the +ollo!ing e3a$-le"
( ) ( ) ( ) [ ] 1 0* 0 1 03 0 1 1 0 1
3
1
+ + + . . . average geometric
( ) ( ) ( ) [ ] 1 0* 0 1 03 0 1 1 0 1
3333 0
+ + +
.
. . .
.6) *
This rate re-resents an average rate over the -erio, in the sense that
re-lacing each iniviual rate #y this +igure !oul lea to the sa$e +inal
result as using the iniviual +igures"
This can #e veri+ie #y using the +ollo!ing e3a$-le
( ) ( ) ( ) 0*6) 0 1 0*6) 0 1 0*6) 0 1 . . . return total + + +
16
This calculation, using the geo$etric average return in each -erio, -rouces
the sa$e total return as the -revious calculation"
This +igure coul also #e use in the stanar +uture value +or$ula"
2or e3a$-le, re-eating this calculation using the +uture value +or$ula, $ay
result in the +ollo!ing result"
( )
3
0*6) 0 1 100 . value future +
116
8*1
1
value present
value future
return
1
100
116

16
This e3a$-le illustrates that the +uture value +or$ula is a si$-li+ie case o+
the -rouct o+ each iniviual return, an a--lies in the case that the returns
+or each -erio are the sa$e"
5.5.7. :olatilit$
The volatility o+ a series o+ values $ay #e $easure using the stanar
eviation o+ the set o+ nu$#ers"
In the case o+ $arket -rices, the stanar eviation o+ the -ercentage changes
$ay #e use, rather than the values the$selves"
This $ay a--ly in cases o+ ata series that +ollo! a :rano$ !alk; -rocess,
in !hich case the value o+ each -oint $ay #e #ase on a rano$ value
centre on the -revious -oint, rather than a rano$ value centre on a +i3e
-oint, as $ay #e the case +or ata such as a series o+ cash +lo!s or custo$er
nu$#ers"
5.5.7.1. :olatilit$ over (ifferent time perio(s
The stanar eviation that $ay a--ly over i++erent ti$e +ra$es $ay #e
calculate using the +ollo!ing +or$ula
periods of number deviation dard tan s period deviation dard tan s
8*2
2or e3a$-le, the stanar eviation o+ the $onthly -rice changes o+ a $arket
-rice $ay #e 1L"
The stanar eviation o+ annual -rice changes $ay then #e calculate using
the +ollo!ing e3a$-le"
12 1 deviation dard tan s annual
.8 28
This result is less than t!elve ti$es the $onthly stanar eviation, as
iniviual $onths $ay -artly cancel each other out, leaing to an annual
stanar eviation that $ay #e less than t!elve ti$es the $onthly stanar
eviation"
Technically, this +or$ula $ay only a--ly in cases !here ine-enent rano$
values are ae together, rather than $ulti-lie"
In the case o+ -rice returns, the returns are $ulti-lie, rather than ae"
=o!ever, +or $ost -ractical sets o+ +igures, a si$ilar result $ay occur in each
case"
5.5.7.2. 3ortfolio stan(ar( (eviation
Dhen several ite$s $ay #e co$#ine into a -ort+olio, the stanar eviation
o+ the entire -ort+olio $ay #e esti$ate"
2or e3a$-le, a #usiness $ay have an e3-osure to several ra! $aterial -rices"
The net e3-osure to the $aterial costs $ay then #e esti$ate using a
-ort+olio a--roach"
The +ollo!ing +or$ula $ay #e use +or esti$ating the stanar eviation o+ a
-ort+olio
r sd sd ( ( of ns combinatio all of sum deviation dard tan s
2 1 2 1
8*3
Dhere each ter$ in the e&uation has the +ollo!ing $eaning
!
1
The !eight o+ the +irst asset !ithin the -ort+olio, !ith the total
!eights su$$ing to 1"0"
!
2
The !eight o+ the secon asset !ithin the -ort+olio"
s
1
The stanar eviation o+ the +irst asset"
s
2
The stanar eviation o+ the secon asset"
r The correlation #et!een the returns o+ asset 1 an asset 2"
This +or$ula $ay #e erive +ro$ the e+inition o+ variance, in a situation
!ere several rano$ varia#les are ae to +or$ a single total"
2or e3a$-le, a #usiness $ay have a -rice e3-osure to three ra! $aterials"
The $arket -rices o+ the ra! $aterials $ay vary in line !ith the +igures in
the +ollo!ing e3a$-le"
Stanar 7eviation Deight
Material A 12L 0"3
Material B *L 0"*
Material / 11L 0"2
/orrelation
Material A I Material B 0"0
Material A I Material / <0"2
Material B I Material / 0"8
The correlation o+ a -rice !ith itsel+ is 1, !hile the correlation #et!een
$aterial A an $aterial B is the sa$e as the correlation #et!een $aterial B
an $aterial A"
8*0
The total net -rice e3-osure $ay then #e calculate using the +ollo!ing
e3a$-le"
r sd sd ( ( of ns combinatio all of sum deviation dard tan s
2 1 2 1
P 0"3 3 0"3 3 12 3 12 3 1 M ($aterial A<A)
0"3 3 0"* 3 12 3 * 3 0"0 M ($aterial A<B)
0"3 3 0"2 3 12 3 11 3 <0"2 M ($aterial A</)
0"* 3 0"3 3 * 3 12 3 0"0 M ($aterial B<A)
0"* 3 0"* 3 * 3 * 3 1 M ($aterial B<B)
0"* 3 0"2 3 * 3 11 3 0"8 M ($aterial B</)
0"2 3 0"3 3 11 3 12 3 <0"2 M ($aterial /<A)
0"2 3 0"* 3 11 3 * 3 0"8 M ($aterial /<B)
0"2 3 0"2 3 11 3 11 3 1 M ($aterial /</)
P )"0 L
In this e3a$-le, the total e3-osure o+ the #usiness costs $ay have a stanar
eviation o+ )L, #ase on the correlations, !eights an stanar eviations
o+ the -rice changes o+ the three ra! $aterials"
,ndependent varia"les
An :ine-enent; set o+ varia#les $ay involve a set o+ varia#les in !hich the
value o+ one varia#le $ay not #e relate to the value o+ another varia#le"
In this case, the correlation #et!een the values $ay #e @ero"
2or e3a$-le, this $ay occur in situations such as -ort+olios o+ #ank loans or
insurance risks"
In the case o+ ine-enent varia#les, the +or$ula $ay #e si$-li+ie to the
+ollo!ing e3a$-le"
asset each for deviation dard tan s ( of sum deviation dard tan s
2 2

()uall* weighted portfolios
8**
An :e&ually !eighte; -ort+olio $ay involve a -ort+olio in !hich each asset
has the sa$e !eight !ithin the -ort+olio"
As an e3a$-le o+ the general e++ect o+ iversi+ication, in the case o+ an
e&ually !eighte -ort+olio o+ ine-enent assets, !here each asset ha the
sa$e stanar eviation, +ollo!ing +or$ula $ay a--ly"
assets of number
asset an of deviation dard tan s
deviation dard tan s
This +or$ula $ay #e erive #y a--lying the general +or$ula to this
-articular case"
5.5.8. 7nertain as. flo5s
In so$e situations, such a loan structures, the si@e o+ each cash +lo! $ay #e
kno!n in avance"
In other situations, the si@e o+ a cash +lo! $ay #e uncertain"
There $ay #e a -ro#a#ility that the cash +lo! $ay not occur, such as a
e+ault on a -ay$ent that is ue, or an e3-ense not #eing re&uire +or one
reason or another"
Also, a cash +lo! $ay have several -ossi#le values"
2or e3a$-le, +uture inco$e +ro$ a -ro9ect evelo-$ent $ay have an
unkno!n value, !hile the value o+ a +inancial instru$ent $ay #e linke to a
volatile $arket -rice"
In these situations, each cash +lo! can #e re-lace #y its e++ective value,
#e+ore other calculations are -er+or$e"
The e++ective value o+ a cash +lo! can #e calculate +ro$ the !eighte
average o+ the -ossi#le values, !ith the -ro#a#ility o+ each value occurring
#eing use as the !eight +or that value"
8*)
This calculation e+ines the +una$ental value o+ an uncertain cash +lo! that
$ay occur on a s-eci+ic ate"
S-eci+ic calculations can #e -er+or$e to eter$ine this value in so$e o+ the
+ollo!ing circu$stances"
Single uncertain cash flow
Dhen a cash +lo! has a +i3e value, ho!ever there is a -ro#a#ility that the
cash +lo! $ay or $ay not occur, the e++ective value can #e calculate using
the +ollo!ing +or$ula"
amount y probabilit value effective
In this +or$ula, the -ro#a#ility is the -ro#a#ility that the cash +lo! !ill
occur"
2or e3a$-le, an assu$-tion $ay #e $ae that there $ay #e a 2L chance o+ a
e+ault on a -articular -ay$ent that $ay #e ue"
In other ter$s, a -ro#a#ility o+ 61L, or 0"61, $ay #e assu$e +or receiving
the -ay$ent"
In the case o+ a -ay$ent o+ G10, the e++ective value o+ this -ay$ent coul #e
calculate using the +ollo!ing e3a$-le"
10 61 0 . value
00 81. 5
This +igure coul then #e use in +urther calculations, such as eter$ining the
-resent value o+ the -ay$ent"
5ro#a#ilities can #e calculate +ro$ historical ata using the +ollo!ing
a--roach
value or events total
value or events actual
y probabilit
8*8
2or e3a$-le, i+ 1000 sa$-le -roucts !ere istri#ute an 230 sales
resulte, then the -ro#a#ility o+ a sale occurring +ro$ a sa$-le -rouct coul
#e calculate using the +ollo!ing e3a$-le"
1000
230
y probabilit
23 0.
/ultiple discrete values
In so$e cases, several -ossi#le values $ay e3ist +or the value o+ a cash +lo!"
In these situations, the e++ective value can #e calculate +ro$ the !eighte
average o+ the -ossi#le values, !ith the -ro#a#ility o+ each value occurring
#eing use as the !eight +or the value"
The e++ective value can #e calculate using the +ollo!ing +or$ula
value possible each for value probabiliy of sum value
2or e3a$-le, a set o+ scenarios $ay #e esti$ate +or the value o+ the inco$e
+ro$ a -ro9ect"
5ro#a#ilities coul #e esti$ate, such as in the +ollo!ing e3a$-le"
Inco$e 5ro#a#ility
20 10 L
30 )0 L
*0 30 L
The e++ective value o+ the inco$e a$ount coul then #e calculate using the
+ollo!ing e3a$-le
8*1
value possible each for value probabiliy of sum value
3 0 *0 ) 0 30 1 0 20 . . . value + +
3*
Continuous possi"le values
In so$e cases, a continuous set o+ -ossi#le values coul occur"
This $ay a--ly to the value o+ an asset, +or e3a$-le, or the value o+ a cash
trans+er that !as linke to a $arket -rice"
In these situations, the e++ective value re$ains e&ual to the average value o+
the -ossi#le outco$es"
This value $ay #e esti$ate using a range o+ $ethos, such as $oelling the
-ossi#le values as a large nu$#er o+ s$all #ans, or creating a co$-uter
si$ulation o+ the -ossi#le results"
These $ethos are iscusse in $ore etail in the section #eginning on -age
)00"
5.5.9. Disount rates
A iscount rate $ust #e selecte in orer to -re+or$ a -resent value
calculation"
In nu$#er o+ issues $ay #e relevant in selecting a iscount rate"
5.5.9.1. Eno5n rates
In so$e situations, the iscount rate that a--lies to a -articular situation $ay
#e kno!n"
8*6
2or e3a$-le, the interest rate o+ a loan $ay #e a s-eci+ie +igure"
Also, a :hurle rate; $ay #e use !ithin an organisation +or the calculation
o+ -ro9ect net -resent values"
2or e3a$-le, a hurle rate o+ 1*L $ay #e use"
In this case, net<-resent<value calculations coul #e -er+or$e using a
iscount rate o+ 1*L"
A -ositive or negative net<-resent<value +igure $ay then #e use to
eter$ine !hether a -ro9ect -roceee or not"
In other situations, a s-eci+ic interest rate or iscount rate $ay not a--ly"
2or e3a$-le, a +uture -ay$ent $ay #e converte to a -resent value, or the
net<-resent<value o+ a large -ro9ect $ay #e calculate"
In these situations, a iscount rate $ust #e selecte in orer to -er+or$ the
calculations"
5.5.9.2. T.e struture of a rate
Interest rates an iscount rates can #e ivie into a nu$#er o+ co$-onents"
Technically s-eaking, these co$-onents shoul #e $ulti-lie together in
orer to eter$ine a total rate"
=o!ever, +or $ost -ractical values o+ the relevant co$-onents, a si$ilar
result occurs #y aing the co$-onents together"
Also, each co$-onent is o+ten an esti$ate in any case, an so the -recision
that $ay #e involve in a correct calculation $ay not result in any ae
#ene+it"
(%ample rate structure
As an e3a$-le o+ the co$-onents o+ an interest rate, the interest rate o+ a +ive
year cor-orate #on $ay #e 11L"
Ane a--roach to revie!ing the interest rate $ay involve eco$-osing the
rate into the +ollo!ing co$-onents"
8)0
3L /reit risk -re$iu$
1L Aitional -re$iu$ +or ter$, i"e" a long<ter$ #on
3 L Real rate o+ return
0 L In+lation e3-ectation
11 L Total interest rate
In this e3a$-le, the interest rate o+ 11L o+ the #on is eco$-ose into +our
ine-enent co$-onents"
The in+lation co$-onent involves an interest return in orer to ensure that the
value o+ the su$ o+ $oney re$ains sta#le"
In the case o+ an in+lation rate o+ *L, +or e3a$-le, this in+lation +igure !oul
i$-ly that a +i3e su$ o+ $oney !oul ecrease in value #y *L each year"
An interest rate o+ *L !oul involve a cash +lo! o+ interest -ay$ents"
The actual value o+ this su$ o+ $oney !oul then re$ain constant, !ith the
increase in the ollar a$ount o+ the +uns #eing e&ual to the increase in
-rices throughout the econo$y"
The :real rate; o+ return re-resents the increase in value that is involve in
the lening transaction"
This is si$ilar to a +ee +or #orro!ing an asset, an is the e++ective return to
the lener"
In the case o+ long ter$ +i3e rates, an aitional :ter$; -re$iu$ $ay #e
involve"
An average, long<ter$ +i3e rates $ay #e higher than short<ter$ rates"
A nu$#er o+ -ossi#le reasons have #een -ro-ose to e3-lain !hy this e++ect
occurs"
8)1
5ossi#le e3-lanations inclue the +act that the value o+ long<ter$ +i3e<
interest securities has a higher volatility than an e&uivalent short<ter$
security, an the -ossi#ility that #orro!ers $ay -re+er to #orro! +or long
ter$ -erios in orer to ensure a su--ly o+ ca-ital, !hile leners $ay -re+er
short<ter$ -erios in orer to retain access to +uns"
The :creit risk; -re$iu$ is a co$-onent o+ the interest rate that re+lects the
chance o+ a e+ault occurring on the #on -ay$ents"
This value $ay #e a--ro3i$ately e&ual to the -ro#a#ility o+ a loss o+ value,
ue to an insolvency o+ the co$-any"
5.5.9.3. Disount rates
5.5.9.3.1. ,is6 premiums
In the case o+ iscount rates that are a--lie to +uture cash +lo!s, the
+ollo!ing rate structure -resents one -ossi#le set o+ rate co$-onents"
Risk -re$iu$ a
Real rate o+ return #
In+lation e3-ectation c
Total iscount rate a M # M c
The in+lation rate varies consiera#ly +ro$ ti$e to ti$e"
In Australia over the last 100 years, the in+lation rate has varie #et!een
rates o+ close to @ero, an rates o+ aroun 1*L"
Si$ilar results have occurre in $ost other evelo-e econo$ies"
An average +igure o+ aroun 3L has a--lie over the long ter$"
Real rates o+ return vary !ithin a $uch narro!er #an than in+lation or the
total interest rate"
Real rates o+ return have varie in a range +ro$ a--ro3i$ately <1L to M*L"
8)2
An average real rate o+ return in sta#le econo$ic conitions is aroun 3L"
Base rates
In eter$ining a iscount rate, a :#ase rate; $ay #e use"
The #ase rate $ay #e a #ank lening rate that is use as a re+erence rate +or
lening, or a ty-ical interest rate that $ay a--ly to lo!<risk assets such as
govern$ent #ons"
Hsing a #ase interest rate $ay then lea to the +ollo!ing structure +or a
iscount rate
Risk -re$iu$ a
Base rate #
Total iscount rate a M #
In so$e cases, a +loating interest rate $ay #e use as a #ase rate"
=o!ever, uring ti$es o+ -articularly high or lo! +loating rates, a long<ter$
rate $ay #e use as the #ase rate"
2or e3a$-le, in the case o+ very long ter$ -ro9ections, a rate such as a 20<
year govern$ent #on rate $ay #e use to esti$ate a long ter$ #ase interest
rate"
In the case o+ shorter -erios, a ter$ $ay #e selecte that $ay cover the
$a9ority o+ the -erio o+ the cash +lo!s"
This $ay allo! #oth the e3-ecte in+lation, an the e3-ecte average +loating
rate over the -erio to #e inclue !ithin the #ase rate +igure"
2or e3a$-le, in the case o+ cash +lo!s that $ay e3tene over +ive years, the
rate o+ a +ive<year govern$ent #on $ay #e selecte as a #ase rate"
(>> co$-onents o+ #ase rates, $atching ter$s !ith i++erent ter$ cash +lo!s)
8)3
$isk premiums
The risk -re$iu$ that is selecte $ay #e #ase on the risk that is involve in
the -ro9ect"
A high risk -re$iu$ $ay #e relevant +or -ro9ects or structures !ith volatile
cash +lo!s, or !ith uncertain outco$es"
/onversely, a lo! risk -re$iu$ $ay #e relevant in the case o+ cash +lo!s
that are sta#le an -reicta#le"
8)0
Suggested risk premiums
The +ollo!ing ta#le -resents so$e -ossi#le risk -re$iu$ ranges +or i++erent
situations an -ro9ects"
Activit* $isk Premium
$ange
(%amples
,o! risk 2L < 0L Sta#le -ro-erty invest$ents,
in+rastructure invest$ents such as
toll roas, govern$ent #ons,
highly<rate cor-orate #ons
Meiu$ risk 0L < 1L 5urchasing an e3isting sta#le
#usiness, graual e3-ansion o+ a
success+ul -rouct, constructing
+acilities that have a salea#le value"
=igh risk 1L < 2*L 4e! #usiness start<u-s, -rouct
evelo-$ents o+ e3-eri$ental
esigns, launching -roucts !ithin
co$-letely ne! $arkets"
2igure 12
2or e3a$-le, a #ase rate o+ 1L $ay currently #e use #y a large #ank as a
re+erence rate +or lening"
A -ro9ect to construct a ne! +acility to #e sol on co$-letion $ay #e
-lanne"
Base on the nature o+ the +acility #eing constructe, an esti$ate $ay #e
$ae that the -ro9ect has a $eiu$<risk nature, an a risk -re$iu$ o+ )L
$ay #e chosen"
8)*
The iscount rate coul then #e eter$ine using the +ollo!ing a--roach"
Risk -re$iu$ )L
Base rate 1L
7iscount rate 10L
This iscount rate o+ 10L coul then #e use to calculate the -resent value o+
the -ro9ect costs an inco$e, an to eter$ine a net<-resent<value +or the
-ro9ect"
5.5.9.3.2. T.e ost of apital
5.5.9.3.2.1. T.e +apital 'sset 3riing -o(el
The /a-ital Asset 5ricing Moel is a theoretical $oel o+ asset -rices"
This $oel is #ase on an argu$ent that involves the -rice o+ assets #eing set
#y $arket +orces, #ase on the correlation o+ returns #et!een i++erent assets"
Hner this $oel, the e3-ecte rate o+ return o+ an asset $ay #e esti$ate
+ro$ the rate o+ return o+ the entire $arket o+ assets, an the correlation
#et!een the asset in &uestion an the $arket"
The /A5M e&uation $ay a--ear in the +ollo!ing +or$
( )
f f m s
r r r r
A key +actor in this $oel is the :#eta; o+ the asset, !hich is re-resente #y
the (reek letter V"
In this e&uation, the #eta re-resents the ter$ in a regression e&uation #et!een
the asset returns an the $arket returns (>> regression vs" -ro#a#ilities)
8))
This +igure $ay #e esti$ate +ro$ a regression -rocess, using a set o+
historical asset -rice returns an historical $arket returns"
A ty-ical asset $ay have a #eta value o+ 1"
Beta values o+ $ore than 1 $ay a--ly to highly volatile assets, !hile #eta
values o+ less than 1 $ay a--ly to assets !ith lo! volatility, or !ith a lo!
correlation to the $arket return"
The ter$
m
r
re+ers to the e3-ecte long<ter$ return o+ the $arket"
The ter$
f
r
re+ers to a risk<+ree interest rate, such as a rate than $ay #e
availa#le on a short ter$ govern$ent #on"
As an e3a$-le, the +ollo!ing +igures $ay #e esti$ate
r
m
1
r
f
*
2 1.
Hsing these +igures, the esti$ate long<ter$ return o+ the asset coul #y
calculate using the +ollo!ing e3a$-le
( )
f f m s
r r r r
( ) 0* 0 0* 0 01 0 2 1 . . . . +
.) 1
The /A5M is use as a +ounation +or asset return $oelling, an
-articularly +or eter$ining iscount rates"
=o!ever, this $oel rests on a nu$#er o+ signi+icant assu$-tions"
8)8
The $ost signi+icant o+ these $ay #e the assu$-tion that the -rice o+ assets is
set #y a :$ean<variance o-ti$isation; -rocess"
This $ay re&uire that the great $a9ority o+ invest$ent ecisions are #ase on
the a++ect that an asset $ay have on the risk o+ a -ort+olio, !hen ae to a
iversi+ie -ort+olio o+ assets"
This assu$-tion $ay have a &uestiona#le #asis in reality"
%$-irical tests o+ the /A5M, co$-aring e3-ecte returns to actual returns,
have -rouce $i3e results"
=o!ever, in the a#sence o+ alternative $oels, the /A5M $ay #e use to
select iscount rates an esti$ate asset returns"
Also, the /A5M $ay introuce a volatility a9ust$ent into the eter$ination
o+ iscount rates, !hich $ay #e consistent !ith the general a--roach o+
increasing iscount rates +or higher risk -ro9ects"
Alternatively, a iscount rate $ay #e eter$ine #y selecting a #ase rate an
a risk -re$iu$, #ase on the overall risk an volatility o+ a -ro9ect"
5.5.9.3.2.2. Beig.te( 'verage +ost of +apital
The esti$ate long ter$ return +or an asset, as calculate +ro$ the /A5M, is
also kno!n as the :cost o+ e&uity;"
This +igure $ay #e co$-are to the :cost o+ e#t;, #eing the interest rate o+
the e#t +uns"
In the #usiness<centre +inancing vie!, e#t an e&uity are si$-ly alternative
$ethos o+ raising ca-ital"
Interest costs $ust #e -ai on e#t, !hile the esti$ate return $ay re+lect the
e3-ecte return on the e&uity +uns"
A !eighte average o+ the t!o +igures $ay #e use to eter$ine the average
cost o+ ca-ital +or the #usinessCs entire ca-ital"
This value $ay #e calculate using the +ollo!ing a--roach"
8)1
e!uity debt
e!uity of t cos e!uity debt of t cos debt
capital of t cos average (eighted
+
+

2or e3a$-le, the +ollo!ing +igures $ay a--ly to a -articular situation

7e#t G20
%&uity G80
7e#t interest rate 1L
/ost o+ e&uity (calculate +ro$ /A5M) 12 L
The e++ective average cost o+ the #usinessCs ca-ital $ay then #e calculate
using the +ollo!ing e3a$-le"
80 20
12 0 80 01 0 20
+
+

. .
capital of t cos average (eighted
.1 11
This +igure $ay #e e&uivalent to a e#t interest rate i+ the #usiness !as
+une entirely through e#t, or a cost o+ e&uity value, i+ the #usiness !as
+une entirely !ith e&uity"
The !eighte average cost o+ ca-ital +igure $ay have use as a iscount rate
+or iscounting cash +lo!s +or ne! -roucts, -ro9ects an so on"
Alternatively, a iscount rate coul #e selecte +ro$ a #ase rate, an a risk
-re$iu$ $ay #e ae #ase on the risk an volatility o+ the -ro9ect"

5.5.9.4. ,eal rate alulations
8)6
In the case o+ long<ter$ -ro9ections, rather than iscounting s-eci+ic cash
+lo!s, calculations $ay #e #ase on real, rather than no$inal, changes"
A no$inal rate or value re+lects an actual -rice or cash +lo!, !hile a :real;
value re-resents a value that has #een a9uste +or in+lation"
In these situations, initial +igures $ay #e esti$ate +or sales, costs an so on"
2igures $ay also #e esti$ate +or annual increases in sales an costs"
In these cases, an in+lation co$-onent coul #e inclue in #oth the iscount
rate an the cash +lo! -ro9ections, or the in+lation co$-onent $ay #e
re$ove +ro$ #oth ite$s"
2or e3a$-le, the +ollo!ing ta#le -resents t!o sets o+ +igures +or a -ro9ect"
The +irst set o+ +igure uses actual -ro9ections +or sales values, an uses a
iscount rate that inclues an in+lation co$-onent"
The secon set o+ +igures esti$ates a real gro!th rate in sales, an uses a
iscount rate that oes not contain an in+lation co$-onent"
4nflation 5< "<
#ales inrease 7< 2<
Disount rate 12< 7<
;ear =ominal 3resent ,eal 3resent
#ales :alue #ales :alue
" 1?""" 1?""" 1?""" 1?"""
1 1?"71 953 1?"2" 953
2 1?147 9"9 1?"4" 9"9
3 1?228 8!! 1?"!1 8!!
4 1?31! 82! 1?"82 82!
5 1?4"9 787 1?1"4 787
! 1?5"9 75" 1?12! 75"
7 1?!1! 715 1?149 715
8 1?731 !82 1?172 !82
9 1?854 !5" 1?195 !5"
=et present 8?139 8?139
880
value
5ossi#le #ene+its !ith using the real calculations inclue the +act that an
in+lation value oes not nee to #e esti$ate, an also that the unerlying
increases or ecreases in value $ay #e clearer in this case"
5.5.1". 4ssues in time value alulations
5.5.1".1.3erio(s & ompoun(ing
/o$-oun interest occurs !hen interest is -ai an re<investe in the total
#alance"
2or e3a$-le, interest $ay #e -ai on a e-osit annually, !ith the total
a$ount #eing investe +or a +urther year"
Although actual interest -ay$ents $ay not #e involve in -resent value an
+uture value calculations, these calculations generally assu$e that a
co$-ouning e++ect occurs"
2or e3a$-le, the stanar -resent value +or$ula a--lies in cases !here
co$-ouning occurs in each -erio"

In the case o+ loans, the co$-ouning +re&uency o+ the loan calculation $ay
#e e&ual to the -ay$ent +re&uency"
In calculations that a--ly to each -ay$ent as it occurs, the net e++ect is that
the co$-ouning +re&uency #eco$es e&ual to the -ay$ent +re&uency"
2or e3a$-le, in a loan !here $onthly -ay$ents !ere $ae, interest
calculations coul also #e -er+or$e using $onthly -erios"
Pa*ment8compounding period conversions
In so$e cases, the -ay$ent +re&uency $ay not #e the sa$e as the
co$-ouning +re&uency"
2or e3a$-le, -ay$ents $ay #e $ae $onthly, !ith interest calculations
#eing -er+or$e on a &uarterly #asis"
881
In these situations, the +ollo!ing conversions coul #e -er+or$e to ena#le
the stanar +or$ulas to #e use"
years of number year per periods g compoundin periods of number
year per periods g compoundin
rate erest int annual al min no
rate erest int
year per periods g compoundin
year per periods payment
payment actual payment effective
year per periods payment
year per periods g compoundin
payment effective payment actual
2or e3a$-le, a 8 year loan +or G100, at an interest rate o+ 1L, $ay involve
$onthly -ay$ents, !ith interest calculations #eing -er+or$e &uarterly"
The re-ay$ents on a loan o+ this ty-e coul #e calculate using the +ollo!ing
e3a$-le
21 8 0 periods of number
02 0
0
01 0
.
.
rate erest int
( )
21
02 0 1 1
02 0
100

+

.
.
payment effective
80 0. 5
12
0
8 0 . payment actual
*8 1. 5
882
5.5.1".2.4nterest rate onversions
The interest rate that is relevant +or -resent value +or$ulas is the interest rate
that a--lies to a single co$-ouning -erio"
2or e3a$-le, a structure involving $onthly calculations $ay use a $onthly
interest rate"
=o!ever, interest rates a generally -resente as annual +igures"
A :no$inal annual interest rate; is an annual rate that re-resents the actual
interest rate"
This is calculate #y using the +ollo!ing +or$ula
year per periods period per rate rate annual al min no
=o!ever, !hen there is $ore than one -erio -er year, the actual rate over a
+ull year $ay #e slightly higher than this, ue to the co$-oun interest e++ect
occurring !ithin the year"
An :e++ective annual rate; is the e&uivalent rate that !oul a--ly to
calculations -er+or$e over a single -erio o+ a year"
2or e3a$-le, an a$ount o+ G10 coul #e e-osite at a no$inal rate o+ 8L
-er annu$, !ith interest calculate an -ai $onthly"
The -er<-erio rate can #e calculate using the +ollo!ing e3a$-le"
year per periods
rate annual al min no
period per rate
12
08 0.

00*133 0.
883
Hsing the +uture value +or$ula, the value o+ the G10 !oul have the
+ollo!ing e&uivalent value at the en o+ a +ull year"
( )
n
y amount value future + 1
( )
12
00*133 0 1 10 . +
81 1*. 5
Hsing si$-le interest, an a$ount o+ G10 +or one year at 8L !oul result in
the +ollo!ing value
100
8
10 10 + value
)0 1*. 5
This illustrates that the no$inal rate oes not s-eci+y the e++ective annual
rate, as an aitional G0"11 a$ount occurre ue to co$-ouning"
The e++ective annual rate s-eci+ies that actual return that !oul occur over a
+ull year"
In contrast, the no$inal rate a--lies to a single -erio, such as a $onth, #ut is
$ulti-lie #y the nu$#er o+ -erios to re-resent an a--ro3i$ate annual
+igure"
/onversions #et!een no$inal an e++ective rates can #e -er+or$e using the
+ollo!ing +or$ulas
1 1

,
_

+
year per periods num
year per periods num
rate annual al min no
rate annual effective
( ) 1 1
1
+

,
_

year per perionds num

rate annual effective rate annual al min no
880
2or e3a$-le, a no$inal annual rate o+ 6L -aya#le $onthly, coul #e
converte into the e&uivalent e++ective annual rate using the +ollo!ing
calculation"
1
12
06 0
1
12

,
_

+
.
rate annual effective
.31 6
Rates that are e3-resse in a +or$ such as :8L -aya#le $onthly; $ay #e
no$inal rates, unless they are s-eci+ie to #e e++ective annual rates"
5.5.1".3.+ontinuousl$ ompoun(ing rates
A co$-ouning +re&uency $ay #e annual, se$i<annual, &uarterly, $onthly,
aily, or so$e other -erio, e-ening on the -articular situation"
The co$-ouning +re&uency can also #e reuce until it reaches the li$it o+
co$-ouning occurring continuously, !ith an in+inite nu$#er o+
co$-ouning -erios"
This is kno!n as a continuously co$-ouning rate"
/ontinuously co$-ouning rates $ay #e use in a nu$#er o+ situations, an
$ay #e use+ul in the case o+ invest$ent returns, !here an unerlying
invest$ent $ay increase in si@e on a continuous #asis, rather than increasing
ue to s-eci+ic interest -ay$ents"
The continuously co$-ouning rate can #e calculate +ro$ the e++ective
annual rate using the +ollo!ing +or$ula"
( ) rate annual effective ln rate g compoundin ly continuous + 1
88*
In this +or$ula, the +unction :ln; is the natural logarith$, an is availa#le as
a +unction !ithin so$e calculators, an also in so+t!are such as s-reasheet
-rogra$s"
2or e3a$-le, an e++ective annual rate o+ 12L coul #e converte to the
e&uivalent continuously co$-ouning rate using the +ollo!ing e3a$-le"

,
_

+
100
12
1 ln rate g compoundin ly continuous
.3 11
The continuously co$-ouning +igure is al!ays less than no$inal or
e++ective +igures, as the continuously co$-ouning +igure incor-orates the
li$it o+ the co$-ouning e++ect than $ay occur !ithin a rate"
The no$inal, e++ective an continuously co$-ouning +igures all re-resent
the sa$e unerlying interest rate, an are si$-ly alternative !ays o+
e3-ressing a single rate o+ increase or iscount"
88)
5.5.11. /inane terms & abbreviations
A$ortising structure A structure in !hich the -rinci-al a$ount reuces
to @ero through the ter$ o+ a loan" In the $ore
general case o+ cash +lo!s, !ithout assu$ing a
:loan #alance; or :outstaning -rinci-al; conce-t,
an a$ortising structure is one in !hich a series o+
regular -ay$ents $ay #e $ae, !ithout a large
-ay$ents #eing involve at the en o+ the ter$ o+
the structure"
Annuity A series o+ regular -ay$ents, such as inco$e +ro$
licence +ees, or re-ay$ents o+ a loan"
/A5M /a-ital Asset 5ricing Moel" This is a theoretical
$oel o+ the -ricing o+ securities an assets, that
$ay #e use to esti$ate a cost o+ e&uity an an
esti$ate return +ro$ an asset"
/ou-on -ay$ent A -ay$ent o+ a #on, !hich is e++ectively an
interest -ay$ent" /ou-on -ay$ents +ro$ a #on
$ay o+ten #e -ai t!ice<yearly"
/ou-on rate The rate o+ interest -ai on a #on" This ter$
erives +ro$ early #ons, !hich ha s$all -a-er
cou-ons attache +or each interest -ay$ent, !ith
each cou-on #eing use to clai$ an interest
-ay$ent on the relevant ate"
7/2 7iscounte /ash 2lo!" This ter$ 7/2 value or
7/2 analysis $ay #e use in re+erence to
calculating an 45'" A 7/2 value $ay a--ly to a
set o+ cash +lo!s, !hile an 45' coul also #e
calculate +or asset values"
7iscount rate A rate that is use to reuce a +uture value to an
e&uivalent value on an earlier ate"
2ace 'alue The value that is -ai at the en o+ the ter$ o+ a
#on or iscount security" Dhen a #on is issue at
an interest rate that is e&ual to current $arket rates,
the +ace value $ay #e e&ual to the initial a$ount
that is investe to -urchase the #on"
2uture 'alue The e&uivalent value o+ a cash +lo! on a later ate"
=urle rate A target invest$ent rate that is use as a iscount
rate !ithin an organisation" The hurle rate $ay #e
use as a iscount rate to calculate an 45'" A
-ositive 45' +igure $ay then suggest that the
-ro9ect returns $ay e3cee the $ini$u$ hurle
888
rate o+ return, an this $ay #e use to eter$ine
!hether to -rocee !ith a -ro9ect or not
Interest rate A rate that s-eci+ies a -ercentage rate o+ interest
-ay$ent on an a$ount o+ a e#t" 2or e3a$-le, a
e#t o+ G10 at an interest rate o+ 10L, $ay
corres-on to an interest -ay$ent o+ G1"
IRR Internal Rate o+ Return" This +igure is the iscount
rate that results in the net -resent value o+ a set o+
-ositive an negative cash +lo!s #eing @ero" This
$ay #e inter-rete as an invest$ent return +ro$ a
set o+ cash +lo!s, although this $ay only strictly
a--ly !hen early cash +lo!s coul #e re<investe at
the IRR rate"
45' 4et 5resent 'alue" The 45' is the su$ o+ the
-resent value o+ several -ay$ents, such as a set o+
inco$e an e3-ense -ay$ents" The 45' is the
e++ective value o+ the co$#ination o+ cash +lo!s, as
a single +igure on a single ate"
5resent 'alue The e&uivalent value o+ a cash +lo! on an earlier
ate"
Risk -re$iu$ An aitional co$-onent that is ae to a #ase
rate to eter$ine a iscount rate" The risk -re$iu$
reuces the value o+ a cash +lo! or -ro9ect, to
re+lect the risk or volatility that $ay #e involve in
the activity"
Risk<a9uste iscount
rate
A iscount rate that inclues a risk -re$iu$, to
a9ust +or the e++ect o+ the risk o+ a -ro9ect or cash
+lo!"
DA// Deighte Average /ost o+ /a-ital" This +igure is
eter$ine +ro$ !eighte average o+ the cost o+
e#t, #eing the e#t interest rate, an the cost o+
e&uity, !hich $ay #e eter$ine +ro$ the /A5M"
The DA// +igure $ay #e inter-rete as the
e++ective cost o+ the #usinessCs total ca-ital, an
this +igure $ay #e use as a iscount rate, +or
calculating a net -resent value +or cash +lo!s such
as ne! -ro9ects"
881
#.&. Economics
%cono$ics is concerne !ith &uestions a#out trae an -rouction"
This involves so$e ee-ly +una$ental issues"
There are several ieas involving econo$ics that are relevant to #usiness"
5.!.1. -one$
Money can #e consiere to #e an ite$ o+ value, in a si$ilar !ay to gol,
#uilings an e&ui-$ent"
In this sense, $oney is si$-ly another ite$ o+ value, along !ith $any other
ite$s o+ value"
This conce-t is i$-ortant in the conte3t o+ trae"
Money as a co$$oity is -articularly illustrate !hen +oreign currencies are
involve"
A #usiness $ay hol Australian ollars, S!iss 2rancs, Thai Baht an
Fa-anese Wen"
Money $ay #e use as a re+erence -oint +or valuing an asset, ho!ever there
is no -articular reason that this nees to #e the case"
2or e3a$-le, a #uiling coul #e value as #eing e&uivalent to 100 trucks,
rather than 200 ollars"
5.!.2. Tra(e
Trae involves e3changing one ite$ +or another"
In $ost cases, one o+ the ite$s involves a su$ o+ $oney"
:Buying; is one sie o+ a trae, an involves e3changing $oney +or another
ite$"
:Selling; one sie o+ a trae, an involves e3changing an ite$ +or $oney"
886
All traes that involve a su$ o+ $oney an an ite$ are a #uying transaction
+or one o+ the -arties, an a selling transaction +or the other -arty"
:Barter; is a trae that involves e3changing one ite$ +or another ite$, !ith
neither ite$ #eing a su$ o+ cash"
:2oreign %3change; is a trae that involves e3changing an a$ount o+ one
currency +or an a$ount o+ another currency"
In all these cases, a trae si$-ly involves e3changing one ite$ +or another
ite$, usually o+ si$ilar value"
'alue is not irectly gaine or lost through trae, #uying or selling"
A trae si$-ly involves trans+or$ing the value that is hel #y the #usiness
into another +or$, such as e3changing cash +or an ite$ o+ e&ui-$ent, or
e3changing an ite$ o+ e&ui-$ent +or cash"
In the case o+ $anu+acturing, as an e3a$-le, the value is create !hen an
ite$ is $ae, not !hen it is sol"
The sale transaction si$-ly involves e3changing a co$-lete ite$ +or
another asset o+ e&ual value, #eing the cash -ay$ent +or the ite$"
5.!.3. 8en(ing an( Borro5ing
,ening an #orro!ing occurs in a !ie range o+ areas !ithin #usiness"
In the co$$ercial conte3t, a +ee is generally -ai +ro$ the #orro!er o+ an
ite$ to the lener, in e3change +or the use o+ the ite$ +or a -erio o+ ti$e"
In the case o+ lening or #orro!ing a #uiling +or occu-ancy, this
corres-ons to rent"
In the case o+ lening or #orro!ing $oney, the +ee corres-ons to interest"
,ening an #orro!ing in e3change +or +ees are co$$ercial transactions, as
is trae"
All loan transactions are a lening arrange$ent +or one -arty, an a
#orro!ing arrange$ent +or the other -arty"
810
5.!.4. +ompetitive a(vantage
In $any cases, a #usiness or an iniviual $ay have the o-tion o+ -roucing
so$ething irectly, or #uying it +ro$ others"
2or e3a$-le, one +ar$er $ay live in an ari area !ith a high level o+
sunshine, access to large areas o+ lan, an an ae&uate rain+all"
Another +ar$er $ay live in a tro-ical area !ith high hu$iity, high rain+all
an li$ite cleare lan"
The +irst +ar$er $ay gro! !heat an -inea--les"
=o!ever, the -inea--les $ay gro! -oorly in the esert environ$ent"
The secon +ar$er $ay also gro! !heat an -inea--les"
=o!ever, in this case the !heat $ay gro! -oorly in the li$ite s-ace an
high hu$iity o+ the tro-ical environ$ent"
Both +ar$ers $ay e3ten consiera#le resources +or li$ite results"
=o!ever, the +irst +ar$er coul evote his entire resources an e++ort to
gro!ing !heat, !hile the secon +ar$er coul gro! only -inea--les"
The +ar$ers coul then trae, !ith the !heat +ar$er traing !heat in
e3change +or -inea--les, an the -inea--le gro!er traing -inea--les +or
!heat"
This conce-t is the #asis o+ trae that has occurre +or thousans o+ years"
In this situation, there $ay #e large increase in the availa#le !heat an
-inea--les that !ere -rouce"
This is kno!n as the -rinci-le o+ co$-etitive avantage"
This -rinci-le suggests that a higher out-ut is -rouce #y a #usiness that
-er+or$s the activities that it is in the strongest -osition to -er+or$, an then
traes !ith other -arties to receive other goos an services"
Although the -rinci-le o+ co$-etitive avantage is a +una$ental conce-t,
there are t!o serious li$itations !ith this a--roach"
811
The +irst relates to trans-ort costs"
2resh !ater, +or e3a$-le, coul #e trans-orte in tankers +ro$ high rain+all
areas to esert regions"
=o!ever, this oes not generally occur, as the trans-ort costs !oul #e
-rohi#itive"
So$e goos are too heavily, #ulky or s-oil too &uickly to #e trans-orte long
istances"
2or e3a$-le, !heat is o+ten trae #et!een countries, ho!ever #rea is not,
as #rea is #ulky, s-oils &uickly, an can #e easily $ae as it is neee"
5.!.4.1. #peialisation & tra(e vs. internal resoures &
in(epen(ene
A secon issue relates to ine-enence"
In the -revious e3a$-le, the !heat +ar$er only gro!s only !heat an the
-inea--le gro!er only gro!s -inea--les"
This situation $ay !ork !ithout -ro#le$s +or an e3tene -erio o+ ti$e"
=o!ever, one ay the !heat +ar$er $ay cease o-erations an sto- -roucing
!heat"
This coul ha--en +or a !ie range o+ reasons"
Brea is a sta-le +oo, an !ithout grain +or +lour the -inea--le gro!er coul
#e in serious trou#le"
In other cases, the !heat +ar$er coul take $ore $alicious action"
The !heat +ar$er $ay raise the -rice o+ !heat rastically, or $ake e$ans
o+ the -inea--le gro!er"
The -inea--le gro!er $ay #e +orce to co$-ly !ith the !heat +ar$erCs
e$ans, at least in the short ter$, having no other !ay to o#tain the grain
that !as neee"
812
In e++ect, #y changing +ro$ a generalise, sel+ su++icient e3istence to one
#ase on s-ecialisation an trae, the +ar$er has given the other +ar$er
-o!er over hi$sel+"
This issue has i$-ortant i$-lications in #usiness an in international trae"
2or e3a$-le, uring the 1680Cs, the oil<-roucing nations o+ the Mile %ast,
through the A5%/ organisation, agree !ith each other to increase the -rice
o+ oil ra$atically"
By all raising the -rice at the sa$e ti$e, the oil #uyers ha no choice #ut to
-ay the higher -rices"
Ail is a $a9or in-ut to the econo$ies o+ the Destern !orl"
This action cause a !ave o+ in+lation to +lo! through the econo$ies o+ the
Dest an lea to $a9or structural change"
A trans+er o+ !ealth +ro$ the Dest to the Mile %ast, $easure in hunres
o+ #illions o+ ollars occurre"
The res-onse to this action, a-art +ro$ intense -olitical lo##ying, !as to
evelo- other oil +iels aroun the !orl, such as the 4orth Sea oil +iel
o-erate +ro$ the British Isles"
The higher oil -rice resulte in oil +iels that ha -reviously #een
unecono$ic #eco$ing econo$ically via#le"
An a s$aller scale, this issue $ay arise !hen a #usiness is heavily e-enant
on a single su--lier or custo$er"
Action #y the su--lier or custo$er $ay #e eli#erate, such as the -rice
negotiations +or the sale o+ #ulk co$$oities such as coal, !hich $ay
involve intense negations #et!een a +e! su--liers an a +e! custo$ers"
In other situations a su--lier $ay cease elivery o+ su--lies or a custo$er
$ay cease orering -roucts +or a variety o+ reasons"

Several ste-s $ay #e taken to $ini$ise the risk that this ty-e o+ situation
$ay have a $a9or negative i$-act on the #usiness"
Dhere -ossi#le, sourcing su--lies +ro$ several su--liers, an -roviing
-roucts or services to a !ie range o+ custo$ers, $ay reuce the risk that a
#reak in trae !ith a single custo$er or su--lier $ay have a $a9or i$-act on
the #usiness"
813

Also, #uying an selling in o-en $arkets, rather than irectly !ith iniviual
#usinesses, $ay also reuce the risk o+ -ro#le$s occurring"
2inally, $aintaining internal alternatives $ay also #e -ossi#le in so$e cases"
2or e3a$-le, #ack<u- generators are +re&uently installe in co$$ercial
#uilings to su--ly -o!er i+ the co$$ercial -o!er su--ly +ails +or a -erio
o+ ti$e"
5.!.5. Eonomi 'tivit$
%cono$ic activity relates to the a$ount o+ co$$ercial activity that is
occurring !ithin a region at a -articular ti$e"
This level o+ econo$ic activity $ay vary signi+icantly +ro$ ti$e to ti$e"
%cono$ic activity involves $anu+acturing goos, construction, -er+or$ing
co$$ercial services an so on"
The general level o+ econo$ic activity is $ost co$$only $easure using a
+igure kno!n as the (ross 7o$estic 5rouct gro!th, or si$-ly (75 gro!th"
This +igure is !iely &uote in the #usiness -ress"
(75 gro!th is #ase on surveys that atte$-t to $easure the a--ro3i$ate
change in the total level o+ econo$ic -rouction co$-are to a -revious
-erio, such as the -revious &uarter or year"
7uring recessions, econo$ic -rouction $ay ecline, an (75 gro!th $ay
#e a negative +igure"
The general level o+ econo$ic activity $ay have an i$-act on the sales an
net inco$e o+ a #usiness"
So$e inustries, such as the #uiling inustry, are highly sensitive to the
level o+ econo$ic activity an activity $ay vary !iely #et!een #oo$
conitions an recessions"
Ather inustries, such as +oo retailing, are largely ine-enent o+ the general
level o+ econo$ic activity, an sales $ay not vary greatly +ro$ one econo$ic
environ$ent to another"
810
5.!.!. -anagement of t.e eonom$
The activity !ithin $ost ca-italist econo$ies, incluing the Australian
econo$y, is governe #y the central #ank o+ the country"
In Australia, this is the Reserve Bank o+ Australia, !hich is governe #y a
#oar o+ governors !ho are a--ointe #ase on e3-erience !ithin #usiness,
econo$ics an govern$ent"
The Reserve Bank is governe #y the /onstitution, an is ine-enent o+ the
govern$ent an the -olitical -rocess"
The -ri$ary tool in the control o+ the econo$y is the setting o+ short<ter$
interest rates"
,o! interest rates lea to an increase in #orro!ing, investing an econo$ic
activity, !hile high interest rates $ay lea to a ecline in econo$ic activity"
Strong econo$ic activity $ay #e associate !ith an increase in in+lation,
!ith $ay cause a range o+ serious -ro#le$s !ithin the econo$ic activity o+ a
country"
5.!.7. +$les
So$e inustries are heavily cyclical, an -ass through regular #oo$s an
eclines"
The #uiling inustry +its !ithin this category"
Resiential #uiling -asses through a regular cycle, !hich tens to #e a +our
year cycle, !ith t!o strong years +ollo!e #y t!o !eak years"
This -attern oes not al!ays re-eat an every year is i++erent +ro$ the
-revious one"
=o!ever, there $ay #e large variations in activity at i++erent -erios o+
ti$e"
/o$$ercial #uiling, involving large o++ice #uilings an other structures, is
also cyclical, although over a longer -erio o+ ti$e"
81*
/o$$ercial #uiling $ay e3-eriences a -erio o+ strong activity, !hich $ay
last +ro$ several years to a ecae, +ollo!e #y $any years o+ slo! activity"
5.!.8. #easonalit$
'arious inustries !ithin the econo$y $ay #e highly seasonal"
2or e3a$-le, agricultural -roucts are generally -rouce at certain ti$es o+
the year, !hile retail sales o+ten -eak uring 7ece$#er"
5.!.9. ,eessions an( Booms
The unerlying ai$ o+ econo$ic $anage$ent is usually to -rouce sta#le
long<ter$ gro!th in the econo$y"
=o!ever, $any internal changes $ay ha--en !ithin an econo$y an
e3ternal events $ay also occur that $ay a++ect the level o+ activity"
Also, the tools that are availa#le +or $anaging an econo$y are li$ite"
%cono$ics is not an e3act science, an $any issues concerning the o-eration
an evelo-$ent o+ the econo$y are not +ully unerstoo"
Boo$s, recessions, an e-ressions have occurre in the -ast, an it is likely
that these conitions !ill occur again in the +uture"
2ro$ the #usiness -ers-ective, the i$-lications o+ this are that great changes
$ay occur +ro$ ti$e to ti$e, an that +le3i#ility in o-erations an
evelo-$ent $ay #e an i$-ortant issue +or the survival o+ a #usiness uring
ti$es o+ ra-i econo$ic change"
5.!.1". 4nflation
In+lation is a situation that involves a #roa increase in -rices across $ost
goos an services"
7e+lation involves a #roa +all in -rices"
81)
7e+lation is co$-aratively rare, ho!ever it oes occur at ti$es uring
e-ressions an ti$es o+ very lo! econo$ic activity"
Moerate in+lation $ay not have a signi+icant i$-act on #usiness o-erations"
=igh in+lation, ho!ever, $ay have a nu$#er o+ i$-lications +or the o-eration
o+ a #usiness"
7uring -erios o+ high in+lation, accounting recors $ay #eco$e istorte,
as +igures a--lying to i++erent -erios o+ ti$e $ay have signi+icantly
i++erent e++ective values"
Dhen in+lation is high, large cash +lo!s ue on +uture ates $ay nee to #e
iscounte to -resent values in orer to -ro-erly $anage the +inancing o+ the
#usiness"
2or e3a$-le, a -ay$ent o+ G100 ue in one yearCs ti$e $ay only #e !orth
G1* at toayCs e&uivalent -rice level"
In general #usiness o-erations, this $ay not #e a signi+icant issue"
In situations involving large +uture cash +lo!s, the +or$ulas in the section
#eginning on -age 820 coul #e use to a9ust the +uture value to an
e&uivalent -resent value"
5.!.11. Te.nolog$ & #trutural +.ange
/hanges in inustry structure an the econo$y generally $ay #e closely
relate to evelo-$ents in technology"
2or e3a$-le, agriculture !as once a $a9or -art o+ econo$ic activity,
ho!ever increases in technology an e++iciency have resulte in +oo an
other agricultural -roucts #eing -rouce #y an inustry that re-resents only
a +e! -ercent o+ the total econo$y"
I$-rove$ents in technology in $anu+acturing an $ining, an the use o+
co$-uter syste$s is general #usiness -rocessing, have resulte in $any
inustries $oving +ro$ la#our<intensive -rocesses, to o-erations #ase on
large +i3e assets, high volu$es, lo! costs -er ite$, an lo! out-ut -rices"
Service #usinesses are the gro!th sector o+ the econo$y, an no! co$-rise a
large -ro-ortion o+ all econo$ic activity"
818
5.!.12. 'ggregate profits
%cono$ics -rovies so$e so#ering thoughts +or an iniviual consiering a
#usiness venture"
The -ro+it o+ a #usiness is the increase in the assets !ithin the #usiness ue to
the o-eration o+ the #usiness activities"
Across the econo$y, the econo$y gro!s at a--ro3i$ately 3L -er annu$"
In other ter$s, in a steay state situation, the total increase in assets is
a--ro3i$ately 3L -er year"
At an average in+lation rate o+ 3L, the no$inal ollar increase $ay #e
a--ro3i$ately )L -er annu$"
All non<-u#lic assets are o!ne #y iniviuals, either irectly, or inirectly
through co$-anies an other #usiness structures"
The average iniviual or #usiness, then, !oul -rouce a -ro+it o+ 3L o+ the
a$ount investe in any -articular year"
2or each #usiness that generates a -ro+it a#ove this level, there $ay #e
another #usiness that -rouces a lo!er -ro+it or a loss"
In any given year, a signi+icant -ro-ortion o+ #usinesses $ay recor a loss,
involving negative net inco$e an a ecline in assets"
5.!.13. ,esoure alloation
Resource allocation re+ers to the !ay in !hich resources, ranging +ro$
ca-ital, to e&ui-$ent an services, are allocate to various -ro9ects or
o-erations"
There are t!o #roa a--roaches to resource allocation"
These coul #e escri#e as the :-lanne allocation; $etho, an the
:selecte allocation; $etho"
In the -lanne allocation $etho, ecisions are $ae to allocate resources to
various uses or -ro9ects"
811
In the selecte allocation $etho, the o-eration itsel+ selects !hich resources
to use"
The -lanne allocation $etho is use in the govern$ent sector, in large
cor-orations, an in co$$unist econo$ies"
The selecte allocation $etho is use in ca-italist econo$ies, an in
iniviual enter-rises"
This issue involves +una$ental -ersonal issues in aition to econo$ic
issues"
=o!ever, +ro$ the econo$ic -ers-ective, history has e$onstrate that the
selecte allocation a--roach is +ar su-erior to -lanne allocation in eriving a
greater result +ro$ the availa#le resources"
Several $a9or -ro#le$s $ay occur !ith -lanne allocation"
,ong ti$e elays $ay #e involve #et!een the re&uire$ent +or the resource
a--earing, an the resource +inally #eing availa#le +or use"
This $ay result in -ro9ects taking +ar longer than !oul other!ise #e the
case, in costs #eing higher, an in so$e cases a -ro9ect or activity $ay
si$-ly not #e -ractical"
2or e3a$-le, es-ite the availa#ility o+ a$-le natural resources, ca-ital an
engineering +acilities, large scale -rouction o+ $oern cars i not occur in
the +or$er Soviet Hnion"
Another -ossi#le -ro#le$ $ay relate to the allocation -rocess"
In -ractice, -lanne allocation $ay result in a large a$ount o+ -olitics,
+ighting, an a range o+ activities an techni&ues #eing use in atte$-ts to
secure resources"
This $ay have several i$-lications"
2irst, a resource $ay en u- #eing allocate in a !ay that oes not re+lect the
unerlying uses to !hich the resources coul #e -ut"
Also, a great eal o+ ti$e an e++ort $ay #e s-ent in atte$-ting to secure
resources, rather than in -er+or$ing other activities"
816
This issue $ay have consiera#le i$-lications +or large #usiness
organisations"
,arge organisations e++ectively o-erate using the -lanne allocation $oel,
!hich is #ase on central -lanne allocation o+ resources"
In +act, the ter$ :enter-rise resource -lanning; re+ers to an entire su#<section
o+ so+t!are evelo-$ent an $anage$ent activity"
In theory, the isavantages o+ this a--roach shoul give an avantage to
s$all organisations in co$-arison to large cor-orate activities"
=o!ever, !ithin inustries that o-erate !ith large econo$ies o+ scale, the
econo$ies o+ scale availa#le !ith large organisations generally out!eigh the
isavantages o+ central -lanning"
In other cases, such as ca-ital starvation, -aralyse -ro9ects an -rouct
esigns that cannot #e change, the li$itations o+ -lanne allocation $ay
lea to the colla-se o+ a #usiness"
Ane organisational $oel that #eca$e -o-ular uring the 1660Cs $ay
-otentially increase the selectiveness o+ the allocation -rocess"
This a--roach involve internal e-art$ents charging each other +or -roucts
an services"
This oes not generally involve -hysical trans+ers o+ $oney #et!een #ank
accounts, #ut is inclue as accounting entries !ithin the o-erations o+ the
organisation"
2or e3a$-le, the co$-uter su--ort area $ay charge the a$inistration area
+ees +or su--ort services, !hile a -rouct esign centre $ay charge a
$anu+acturing o-eration licence +ees +or the use o+ a ne! -rouct esign"
%ach area !oul then o-erate !ith a se-arate internal set o+ accounts, an
o-erate as an ine-enent #usiness, !ithin inco$e an e3-enses"
This a--roach $ay assist in highlighting !here the $a9or costs areas occur
!ithin an organisation, an highlight the areas that are o-erating on a
sustaina#le #asis, an those !hich are not"
=o!ever, in -ractice this a--roach $ay have li$ite results"
860
Internal charging has no e++ect on allocation unless a -arty on either sie o+
the arrange$ent, #oth in theory an in -ractice, has the o-tion o+
iscontinuing the arrange$ent an seeking alternative arrange$ents"
In $any situations, this is not the case"
Dith an internal su--lier, altering the level o+ service $ay involve
a--roaching various co$$ittees, su#$itting -ro-osals an #usiness cases
arguing the case +or the aitional su--ort level, or si$-ly continuing
o-erations using !hatever alternative $eans coul #e +oun to reuce the
-ro#le$"
Although resource -lanning $ay #e a co$-onent o+ $any organisations, the
issues involving resource allocation $ay have $a9or i$-lications +or the
structure an o-eration o+ a large cor-orate enter-rise"
5.!.14. T.e apital mar6ets
The ca-ital $arkets are the +acility that allo!s #usinesses to raise +uns +ro$
the general -u#lic"
The ca-ital $arkets an the #anking syste$ are the +ounations o+ econo$ic
activity in a ca-italist econo$y"
2uns $ay #e raise as either e&uity or e#t"
Both -rocesses involve the issue o+ a -ros-ectus, !ith investors su#scri#ing
cash in return +or shares or #ons o+ the co$-any"
The cash that is raise then #eco$es -art o+ the co$-any assets, an $ay #e
use to +un -ro9ects, re-lace +acilities, an e3-an the #usiness"
In the case o+ e&uity, the investors #eco$e -art o!ners o+ the e3-ane
#usiness o-eration, !ith the -revious investors o!ning a s$aller -ro-ortion
o+ a larger enter-rise"
In the case o+ e#t, interest -ay$ents !oul generally #e $ae, !ith the +ace
value o+ the #on #eing re-ai accoring to the ter$s o+ the e#t issue"
Shares are generally liste +or traing on a stock e3change, an #ons $ay
also #e liste"
861
This +acility allo!s an investor to enter a -osition in the #usiness o-eration,
or !ithra! +ro$ the #usiness o-eration, through #uying or selling shares or
#ons"
5.!.15. -ar6ets
A $arket involves a -lace or a situation in !hich a large nu$#er o+ si$ilar
ite$s are #ought an sol"
This $ay inclue so$e o+ the +ollo!ing e3a$-les
2ruit an vegeta#le $arkets"
/ra+t $arkets"
The stock $arket, involving #uying an selling shares in co$-anies"
The $arket +or crue oil"
The la#our $arket +or e$-loy$ent contracts"
The -ro-erty $arket, involving #uying an selling -ro-erty"
The e3istence o+ a $arket si$-ly re&uires a large nu$#er o+ #uyers, an a
large nu$#er o+ sellers, traing a range o+ si$ilar goos
The ter$ :co$$oity; is use to escri#e ite$s or -roucts that are sol in
large volu$es o+ si$ilar goos"
2or e3a$-le, this ter$ coul #e use to re+er to co$$oities such as natural
gas, -a-er, sugar, an stanar co$-uter har!are co$-onents"
5.!.15.1.T$pes of mar6ets
Markets $ay occur in a -articular -hysical location, or traes $ay #e s-rea
#et!een i++erent ti$es an -laces"
2or e3a$-le, a +ruit an vegeta#le $arket $ay take -lace in a large
!arehouse or an o-en air location"
862
A stock $arket $ay #e organise through a stock e3change, !hich $ay
involve an organisation arranging the loge$ent o+ #is an o++ers, an the
settle$ent o+ transactions"
Actual traing coul occur !ithin a single roo$, o+ through a net!ork o+
co$-uter syste$ connections"
In other cases, a $arket $ay not corres-on to a single ti$e, -lace or
activity"
2or e3a$-le, the -ro-erty $arket coul re+er to the -urchase an sale o+ lan
an #uilings, occurring at various ti$es an in various -laces, an arrange
in various !ays"
The la#our $arket involves the $arket +or e$-loy$ent"
Dhile the -rices !ithin a -ro-erty $arket $ay involve the #uying an selling
-rices o+ -ro-erties, the -rices !ithin the la#our $arket $ay corres-on to
the rates an salaries a--lying to various ty-es o+ e$-loy$ent an various
activities"
5.!.15.2.:olatilit$
The -rice o+ goos sol !ithin $arkets $ay #e sta#le, or the -rice $ay #e
highly volatile"
The sta#ility o+ -rices $ay #e relate to the sta#ility o+ the su--ly o+ the
ite$s, an the sta#ility o+ e$an"
2or e3a$-le, the -rices o+ $anu+acture ite$s such as -a-er an steel $ay
#e reasona#ly sta#le, ue to a steay su--ly, a steay e$an, an steay
traing volu$e"
In contrast, the -rice o+ +resh +ruit $ay #e volatile, ue to su--ly varying
!ith the ti$e o+ the year, an the varying !ith the gro!ing conitions !ithin
a -articular season"
The -rices o+ $any co$$oities, incluing agricultural co$$oities, so$e
$ining co$$oities such as $etals an oil, shares, an -ro-erty $ay all #e
highly volatile"
863
5.!.15.3.+$les
So$e $arket -rices an volu$es trae through regular cycles"
These cycles $ay #e -reicta#le, or they $ay occur +or rano$ lengths o+
ti$e"
2or e3a$-le, the su--ly an -rices o+ agricultural -roucts such as !heat an
!ool $ay vary accoring to the ti$e o+ year"
In the case o+ #uiling construction, the level o+ activity $ay #e high +or
several years, +ollo!e #y several years o+ very lo! activity"
5.!.15.4.-ar6et pries
The -rice o+ goos that are #ought an sol !ithin $arkets $ay #e set #y the
+orces o+ su--ly an e$an"
In general, !hen su--ly is li$ite an e$an is high, an ite$ $ay trae at a
high -rice"
/onversely, !hen a large su--ly o+ an ite$ is availa#le, ho!ever e$an is
lo!, the ite$ $ay trae at a lo! -rice"
This e++ect $ay occur ue to the +act that i++erent #uyers $ay have a
i++erent level o+ interest in a -rouct"
2or e3a$-le, so$e #uyers $ay #e !illing to -ay G1 +or an ite$, other #uyers
$ay #e !illing to -ay G10, an other #uyers $ay #e !illing to -ay G12"
In cases !here su--ly is li$ite, traes $ay only occur #et!een sellers an
the #uyers that #i G12, in !hich case the $arket -rice o+ the ite$ !oul #e
G12"
In a case !here a$-le su--ly !as availa#le, all traes $ay #e conucte, an
the $arket -rice $ay +all to G1"
All else #eing e&ual, a $arket -rice $ay sta#ilise at a level that re+lects the
custo$erCs interest in a -rouct, an the -ractical use+ulness o+ the -rouct"
860
Suppl*
In $any situations the unerlying e$an +or a -rouct $ay #e sta#le, an
$ay re+lect the -ractical use+ulness o+ the ite$ in various situations"
=o!ever, the su--ly o+ goos $ay o+ten vary"
2or e3a$-le, the -rice o+ a $ining co$$oity $ay #e high +or an e3tene
-erio o+ ti$e"
In this case, ne! e3-loration $ay #e conucte an ne! $ines $ay #e
evelo-e"
Mines that !ere -reviously unecono$ical ue to a high cost o+ e3tracting the
ore $ay #eco$e econo$ically via#le, an -rouction $ay co$$ence at
these $ines"
These activities $ay result in an increase in su--ly, an $ay result in a +all in
-rice"
In general, the su--ly o+ a -rouct $ay rise or +all e-ening on the -rice"
A high -rice $ay lea to the creation o+ ne! +acilities an increase su--ly,
!hile a lo! -rice $ay lea to closure o+ +acilities an a reuction in su--ly"
=o!ever, a long ti$e elay $ay #e involve in so$e cases, in su--ly levels
a9usting to e$an"
This $ay lea to volatile -rices, an -erios o+ -ro+its or losses !hen su--ly
is lo!er or higher than the unerlying e$an"
So$e o+ the -rice e++ects that $ay occur !ithin $arkets $ay #e su$$arise
in the +ollo!ing -oints"
86*
5rices set #y su--ly an
e$an"
The -rice o+ an ite$ in a $arket is set #y the
availa#le su--ly, an the e$an +or the ite$"
=igh su--ly an lo! e$an $ay result in lo!
-rices, !hile lo! su--ly an high e$an $ay
result in high -rices"
/hanges in su--ly Su--ly $ay a9ust over ti$e, increasing
+ollo!ing -erios o+ high -rices an reucing
+ollo!ing -erios o+ lo! -rices"
/ost o+ -rouction /hanges in su--ly $ay lea to $arket -rices
a9usting to levels that re+lect the unerlying
e$an +or the -rouct, an the costs o+
creating the -rouct"
%&uili#riu$ Dith e$an an su--ly levels constantly
changing, a sta#le -rice level $ay never e3ist,
!ith e$an, su--ly an -rices all changing as
ti$e -asses"
$andom walks
The -rices o+ goos that are trae in $arkets $ay o+ten +ollo! a -rocess
kno!n as a :rano$ !alk;"
In this -rocess, each ne! -rice is #ase on a rano$ value"
The average o+ the ne! -rice is centre on the -revious -rice, in contrast to
$any rano$ ata series, in !hich the ata $ay #e centre on a constant
average -oint"
5.!.15.5.Effiient mar6ets
In so$e cases, changes in -rice levels an volu$es can #e -reicte"
This generally a--lies to the sale o+ co$$oities that cannot #e easily store,
an !here the su--ly $ay vary accoring to the ti$e o+ the year"
2or e3a$-le, the -rice o+ !heat $ay #e lo! +ollo!ing the harvest season,
!hen a large volu$e o+ !heat $ay #e availa#le, an $ay rise through the
year until the ne3t harvest season"
86)
(>> check co$$oity -rice e3a$-les)
=o!ever, in cases !here a co$$oity can #e easily store, or !here the
su--ly is not e-enant on e3ternal conitions, a i++erent e++ect $ay a--ly"
2or e3a$-le, i+ !heat coul #e easily store in large volu$es, then an
investor $ay -urchase the !heat !hen the -rice !as lo!, store the !heat,
an then sell the !heat !hen the -rice !as high"
In atte$-ting this action, the #uying activity $ay increase the -rice uring
the lo! -erios, an the selling activity $ay -ush the -rice o!n uring the
high -erios"
/onucting the s-eculative activity $ay have the e++ect o+ s$oothing the
-rice, an lea to a sta#le -rice through the !hole -erio"
This $ay have several e++ects"
The -rice !oul #e sta#le, an +uture -rices coul not #e -reicte accoring
to a regular cycle or -attern"
Also, a consistent -ro+it or loss !oul not #e -ossi#le, as an accurate
-reiction coul not #e $ae as to !hether the +uture -rice !oul #e higher
or lo!er"
This e++ect is kno!n as an :e++icient $arket;"
Dithin an e++icient $arket, the current $arket -rice $ay settle to a level that
incor-orates the current in+or$ation a#out +uture conitions"
Any changes to -rices !oul occur as a result o+ une3-ecte events
occurring, !ith an e&ual chance o+ -ositive or negative events"
An e++icient $arket has the +ollo!ing characteristics
1" 5rice changes occur on a rano$ #asis"
2" 2uture -rices cannot #e -reicte"
3" 5ro+it or loss on a consistent, long<ter$ #asis ue to s-eculation is
not -ossi#le"
868
=o!ever, although -ro+it or loss $ay not #e -ossi#le +ro$ -reicting +uture
-rices, the $arket ite$s $ay still involve an average long<ter$ return"
2or e3a$-le, shares an -ro-erty coul have an average long ter$ return that
!as a -ositive value, even in the case o+ a -er+ectly e++icient $arket, !hich
!oul $ake any -articular -reiction over a s-eci+ic ti$e +ra$e i$-ossi#le"
A consiera#le volu$e o+ research has #een conucte to investigate !hether
large scale $arkets, such as the stock $arket, are e++icient $arkets or not"
Although results $ay vary, the general conclusion o+ these stuies has #een
that large scale, li&ui $arkets such as the stock an #on $arkets in
evelo-e econo$ies have a very high level o+ e++iciency"
In these situations, the -otential value +ro$ s-eculation $ay #e li$ite in
co$-arison to the levels o+ volatility"
Market e++iciency $ay have a nu$#er o+ i$-lications +or a #usiness
o-eration"
The -ri$ary i$-lication o+ this $ay #e that atte$-ting to -reict the +uture
-rices o+ $arket trae co$$oities $ay not #e !orth!hile !ithin general
#usiness activity"
In these cases, using risk $anage$ent techni&ues such as +utures an o-tions
to $anage -rice risks $ay #e a lo!er<risk a--roach that $anaging -rices
#ase on -reictions o+ +uture -rice levels"
5.!.1!. Eonomi assumptions
In evelo-ing $oels o+ +uture activities, such as esti$ating the inco$e +ro$
a ne! -rouct evelo-$ent, a nu$#er o+ assu$-tions $ay #e neee"
2igures that are use in calculations are either :real; or :no$inal; +igures"
A no$inal +igure is the actual value itsel+, such as an interest rate"
In the conte3t o+ econo$ics an +inance, a :real; +igure is a no$inal +igure
that has #een a9uste +or in+lation"
2or e3a$-le, i+ in+lation !as 10L an the interest rate on a e-osit !as 12L,
then the :real; interest rate !oul #e 2L"
861
The 2L +igure $ay re-resent that actual increase in value that !oul occur
+ro$ the interest -ay$ents"
Technically, the in+lation rate an the real rate shoul #e $ulti-lie together,
not ae, ho!ever an aition or su#traction $ay give a close a--ro3i$ate
result +or $ost -ractical levels o+ in+lation"
Real rates are o+ten reasona#ly sta#le, !hile the no$inal rate $ay rise or +all
signi+icantly !ith changes in in+lation"
The +ollo!ing +igures coul #e use as assu$-tions +or long<ter$ values"
These +igures a--ro3i$ate the values that have occurre over the last 100
years in Australia an in $ost other ca-italist econo$ies"
Real /o$$on
Rate Real Range
%cono$ic gro!th 3 L <1L to M)L
Interest rates 3 L <1L to M*L
In+lation 3L 2L to 1L
The no$inal rate, !hich is the rate that actually a--lies +or a transaction, is
the real rate -lus the in+lation rate"
2or e3a$-le, !hen in+lation is *L an real econo$ic gro!th is 3L, then the
no$inal econo$ic gro!th !oul #e 1L"
Si$ilarly, i+ real interest rates !here 2L, then the interest rates +or actual
transactions !oul #e aroun 8L"
#.). 5inancial Distress
2inancial istress occurs !hen a #usiness enters a situation in !hich there is
a signi+icant chance that it !ill #eco$e insolvent"
4egative cash +lo! occurs in $any #usiness o-erations, such as uring the
evelo-$ent -hase o+ a ne! -ro9ect"
866
=o!ever, +inancial istress a--lies to a situation in !hich a #usiness is at
signi+icant risk o+ insolvency"
The $ay occur !hen cash +lo! is negative, cash reserves are lo!, an no
i$$eiate solution to the -ro#le$ is availa#le or is likely to occur in the
short ter$"
5.7.1. 4nsolven$
Insolvency occurs !hen a #usiness is una#le to $ake a -ay$ent that is ue"
Dhen a #usiness #eco$es insolvent, a creitor $ay $ake an a--lication to a
court to have the #usiness !oun u-"
Dhen this occurs, the o-erations o+ the #usiness are iscontinue, the assets
are sol an the e#ts are re-ai"
Any e3cess +uns that re$ain a+ter the re-ay$ent o+ the e#ts are istri#ute
to the shareholers"
I+ there are insu++icient +uns re$aining to re-ay all the e#ts, the re$aining
e#ts are cancelle in the case o+ a co$-any"
In the case o+ a sole traer o-erating in a -ersonal na$e, a -artnershi-, or
irectorCs guarantees, the iniviuals $ay #eco$e lia#le to re-ay the
re$aining e#ts +ro$ -ersonal assets"
Insolvency oes not occur -urely #ecause o+ negative cash +lo!"
=o!ever, negative cash +lo! is an unsustaina#le situation, an !ill
eventually result in the net assets +alling to @ero an insolvency occurring i+ it
continues +or an e3tene -erio o+ ti$e"
,ike!ise, negative e&uity oes not i$-ly insolvency, although this generally
inicates a serious -ro#le$ !ith the +inancial -osition o+ the #usiness"
5.7.2. +auses of finanial (istress
2inancial istress can #e cause #y a !ie range o+ circu$stances"
100
In so$e cases, a single event $ay #e the cause o+ a +inancial istress
situation"
2or e3a$-le, a +acility $ay #e estroye #y +ire, leaing to an ina#ility to
continue -rouction"
,ong elays $ay occur in re<esta#lishing -rouction, arising +ro$ court
cases or other elays that $ay #e involve in receiving insurance settle$ents"
In the case o+ a single event, the cause o+ the +inancial istress $ay have
alreay -asse, an action $ay #e +ocusse on surviving the i$$eiate
-erio !ithout #eco$ing insolvent, an re<esta#lishing the #usiness
o-eration on a sustaina#le #asis"
In other cases, the cause o+ the -ro#le$ !ill still #e current uring the
+inancial istress -hase"
In these situations, action $ay nee to #e taken to aress the cause o+ the
-ro#le$, in aition to surviving the i$$eiate situation"

So$e causes o+ +inancial istress $ay inclue the +ollo!ing
Hne3-ecte e3ternal events such as a $a9or custo$er iscontinuing
orers, cancellation o+ a -ro9ect, +ire etc"
,ack o+ invest$ent in ne! +acilities, -roucts an -rocesses"
An e3cessive +uning #uren cause #y activities such as large
research an evelo-$ent areas, a large evelo-$ent -ro9ect, or
so$e other o-eration consu$ing +uns that cannot #e su--orte #y
the o-erations o+ the #usiness"
/a-ital starvation, !here e3-enses have #een cut to unsustaina#ly
lo! levels, an +uns are not availa#le +or essential ite$s such as
co$-uter e&ui-$ent an in+or$ation su--lies"
/ontinuing to o-erate loss<$aking +acilities an o-erations that
cannot #e -ro+ita#le ue to their structure an shoul #e close"
5oor $anage$ent o+ the o-erations, structures an costs o+ the
#usiness"
Ine++ective $arketing activities"
101
,o! levels o+ econo$ic activity"
5.7.3. Termination of finanial (istress
A -erio o+ +inancial istress $ay en !hen cash +lo! #eco$es -ositive, or
+ailing that, !hen the #usiness #eco$es insolvent an is li&uiate"
The en o+ a -erio o+ +inancial istress $ay occur in so$e o+ the +ollo!ing
circu$stances"
(eneral traing conitions i$-rove, such as the en o+ a $a9or
econo$ic recession"
Aitional e&uity is raise +ro$ investors to re-ay e#t"
A $a9or cash in+lo! occurs, such as a -ay$ent +or a co$-lete
-ro9ect"
/hanges to the #usiness o-erations result in net cash +lo! turning
aroun an #eco$ing -ositive"
'olatility in in-ut or out-ut -rices results in -ositive cash +lo!
#eing restore"
The ai$ o+ $anaging a #usiness uring a -erio o+ +inancial istress is to
ensure that the #usiness kee-s o-erating, that it re$ains solvent an -ays
e#ts as they are ue, an that it is a#le to avoi insolvency long enough +or
the -erio o+ negative cash +lo! to en"
I+ the negative cash +lo! is ue to -er$anent causes, rather than a te$-orary
issue, this $ay also re&uire a restructure o+ the #usiness to create a
sustaina#le o-eration #e+ore insolvency occurre"
5.7.4. +risis 'ounts
/risis accounts coul #e use as a ter$ to escri#e the +inancial state$ents
neee to $anage a #usiness that is o-erating uner conitions o+ +inancial
istress"
102
/risis accounts are very i++erent +ro$ stanar +inancial state$ents"
Ane a--roach to -re-aring crisis accounts coul involve the +ollo!ing
a--roach"
/reit +acilities availa#le at call, such as unuse overra+t a$ounts,
are inclue !ith cash #alances as availa#le cash levels"
Assets are value at realisa#le value, !hich is the cash a$ount that
coul #e raise +ro$ selling the asset, less any transaction costs"
Assets than cannot #e sol are not inclue"
Accrual accounting is not use, an cash #alances recor -hysical
cash levels, rather than inco$e #ooke +ro$ sales !here -ay$ent
has not #een receive"
4on<cash e3-enses such as e-reciation are not inclue"
All $a9or -ening cash +lo!s are recognise, incluing ca-ital
a$ounts such as in+lo!s +ro$ asset sales"
,i&ui assets, such as shares, are liste se-arately !hen the cash
in+lo! +ro$ selling the asset coul #e receive !ithin a short -erio
o+ ti$e, such as a +e! !eeks
The +ollo!ing e3a$-le -resents one -ossi#le +or$at +or a set o+ crisis
accounts
103
Amount /onths
$emaining
/ash
/ash e-osits 10
Hnuse overra+t +acilities *
Total /ash 1* 1"1
,i&ui Assets
Shares 2*
Total cash . li&ui assets 00 *
Salea#le Assets
%&ui-$ent **
,arge stock ite$s *
'ehicles 2*
Total Salea#le Assets 1*
Total cash, li&ui assets, 12* 1*
. salea#le assets
Monthly cash in+lo! 8*
Monthly cash out+lo! 13
4et cash +lo! < 1
Inco$e #ooke #ut not receive 2*
%3-enses ue #ut not -ai 1*
100
Ma9or u-co$ing cash +lo!s
In+lo!s
Settle$ent o+ #uiling sale 1* 23 2e#ruary
Aut+lo!s
Interest -ay$ent on #ons ** 18 A-ril
10*
All assets !oul #e sol u- to the +inal insolvency ate, in the orer o+ their
i$-ortance to the #usiness o-eration"
Assets that coul not #e re-lace to allo! continue #usiness o-eration
!oul not #e inclue as salea#le assets"
2or e3a$-le, a licence to o-erate !ithin the inustry, an s-ecialise
-rouction +acilities, !oul not #e inclue as salea#le assets"
The orer o+ sale $ay e-en on the si@e o+ the ite$, the net cash that coul
#e raise i+ another ite$ ha to #e -urchase to re-lace it, an the i$-act on
#usiness o-erations"
2or e3a$-le, the licence to o-erate !oul #e the last ite$ to #e sol, as this
!oul then lea to the closure o+ the #usiness"
5.7.5. ,e(uing as. outflo5s
In the case o+ negative cash +lo!, action $ay #e neee to avoi insolvency
occurring unless the negative cash +lo! corres-ons to a short<ter$ situation,
such as the evelo-$ent -hase o+ a -ro9ect"
Ste-s that can #e taken to reuce negative cash +lo!, or to restore -ositive
cash +lo!, $ay inclue so$e o+ the +ollo!ing ite$s"
Raising e&uity
Increasing inco$e
Selling assets
5ost-osing e3-enses
Reucing e3-enses
10)
5.7.!. ,aising e9uit$
In a situation o+ +inancial istress, the #usiness o!ners $ay trans+er
aitional +uns into the #usiness +ro$ -ersonal assets"
I+ this is not -ossi#le, outsie investors $ay #e sought to contri#ute +uns to
the enter-rise an to sta#ilise the +inancial -osition"
In the case o+ a -u#lic co$-any, a rights issue is o+ten conucte to raise
aitional +uns +ro$ the e3isting shareholers an the general -u#lic"
These actions $ay sta#ilise the short ter$ -osition o+ the #usiness"
In cases !here the #usiness is carrying an e3cessive level o+ e#t, raising
e&uity an using the +uns to re-ay the e#t $ay reuce interest costs an
i$-rove the #usiness outlook"
=o!ever, in other cases, si$-ly raising aitional e&uity $ay not solve the
-ro#le$ that cause the original situation to occur, such as negative
o-erating cash +lo!"
Also, the e3isting o!ners an other investors $ay #e reluctant to invest $ore
+uns in a #usiness that is consu$ing ca-ital, as the aitional +uns $ay
also #e lost"
5.7.7. 4nreasing inome
In $ost cases, there $ay #e little irect action that can #e taken to increase
inco$e in the short ter$"
So$e alternatives $ay inclue cancelling iscounts, su#siies an other
#ene+its that are o++ere !ith -roucts"
Dhere -rices are #elo! co$-etitorCs -rices or are unsustaina#ly lo!, raising
-rices $ay increase revenue"
A ecline in the nu$#er o+ sales $ay #e e3-ecte, ho!ever this $ay #e
o++set #y the higher inco$e -er ite$"
In other cases !here -rices are too high, reucing -rices an holing a short
-ro$otional ca$-aign $ay #oost sales"
108
=o!ever, in $any cases this $ay #e unlikely to result in a large short<ter$
increase in the value o+ sales, an is $ore likely to reuce net inco$e"
5.7.8. 3ostponing e)penses
%3-enses such as the -urchase o+ ne! e&ui-$ent, research an evelo-$ent
-ro9ects, $arketing e3-enses an so +orth coul #e -ost-one in the short
ter$ until the +inancial -osition o+ the co$-any ha #een sta#ilise"
=o!ever, these e3-enses $ay #e necessary +or the long ter$ survival an
evelo-$ent o+ the #usiness"
Ane -ossi#le scenario $ay #e that e3-enses o+ this ty-e ha #een -ost-one
in the -ast, no other action !as taken, an that the #usiness is no! in a +ar
$ore serious -osition through having no via#le o-eration going +or!ar"
5.7.9. ,e(uing e)penses
Asie +ro$ selling assets, reucing e3-enses is the other $a9or o-tion
availa#le to the #usiness to -ost-one insolvency"
Reucing e3-enses has the #ene+it that it is a -er$anent change, as o--ose
to so$e o+ the other $easures to raise cash that si$-ly allo! o-eration to
continue +or a -erio o+ ti$e !hile other changes are $ae"
In the case o+ reuce e3-enses, this !oul also reuce the rate o+ ecline in
the net assets o+ the #usiness, in contrast to other alternatives !hich $ay
e3ten the -erio o+ ti$e until insolvency through converting assets into
cash"
Reucing e3-enses $ay involve reucing sta++ nu$#ers, $oving to alterative
-re$ises, closing unecono$ic -rouction +acilities, an +ining alternative
sources +or ra! $aterials an other su--lies"
In cases !ere an internal area is too large to #e sustaine #y the current
#usiness o-erations, such as a large evelo-$ent -ro9ect or a large research
area, a -ro9ect coul #e iscontinue or an internal area coul #e reuce in
si@e"
101
5.7.1". /atoring
Money that is ue +or -ay$ent +ro$ custo$ers is an asset"
This is ue to the +act that -ay$ents $ay #e receive on +uture ates +ro$
accounts that are ue"
This asset is generally recore in the #alance sheet as :accounts receiva#le;
or :trae creitors;"
A +actor service is a #usiness that -urchases accounts receiva#le +ro$ other
#usinesses, an collects the inco$e irectly"
A iscount is a--lie to cover #a e#ts, interest ue to the elay in the
accounts #eco$ing ue, an the +actorCs -ro+it $argin"
The +actor $akes an i$$eiate -ay$ent to the #usiness, an then collects the
accounts as they #eco$e ue"
In a +inancial istress situation, this $etho $ay allo! the #usiness to raise
cash on short notice i+ there is a signi+icant value o+ accounts ue +ro$
custo$ers"
5.7.11. #elling assets
Selling assets $ay #e the $a9or o-tion availa#le to a #usiness to raise su$s
o+ cash in a short -erio o+ ti$e"
This $ay not solve the unerlying -ro#le$ that cause the situation to
evelo-, ho!ever it $ay allo! the #usiness to continue o-erating +or the
short ter$, even uner conitions o+ negative cash +lo!"
This $ay -rovie ti$e to allo! +or a te$-orary -erio o+ lo! inco$e to -ass,
to allo! +or evelo-ing ne! -roucts an custo$er accounts, an to allo!
ti$e to $ake structural changes !ithin the #usiness to create a sustaina#le
#usiness o-eration"
Assets that are not currently use +or #usiness o-erations coul #e irectly
sol"
Assets that !ere use !ithin #usiness o-erations coul #e sol, an
alternative assets coul #e -urchase or lease"
106
A lease arrange$ent !oul allo! the entire -rocees o+ the sale to #e hel as
a cash reserve"
=o!ever, -ro#le$s $ay arise !ith lessors re+using to lease e&ui-$ent ue to
the -oor +inancial -osition o+ the #usiness"
Alternatively, assets coul #e sol an lo!er<cost assets coul #e -urchase
to allo! the #usiness o-eration to continue in the $eiu$ ter$"
Another alternative $ay involve a sale<an<lease#ack arrange$ent, !hich is
so$eti$es use !ith co$$ercial -ro-erties"
In this arrange$ent, the #usiness sells the -ro-erty, #ut re$ains in the
#uiling as a tenant"
A stanar lease is signe !ith the -urchaser o+ the #uiling"
This arrange$ent allo!s the #usiness to raise a lu$- su$ o+ cash !ithout
istur#ing the current o-erations"
5.7.12. +as. & 'sset levels
Insolvency occurs ue to a lack o+ cash, not ue to a lack o+ assets"
A #usiness $ay have su#stantial assets, an yet still #eco$e insolvent i+ there
is insu++icient cash availa#le to $ake -ay$ents that are ue"
This $ay #e a -otential -ro#le$ in a high<gro!th situation"
A large a$ount o+ $aterials $ay have #een -urchase"
A large nu$#er o+ -roucts $ay have #een sol to custo$ers on creit ter$s,
or !ork $ay have #een #ille to clients"
In cases !here inco$e ha not yet #een receive +ro$ custo$ers, ho!ever
e3-enses !ere high, a +inancial istress situation $ay evelo- ue to the
ti$ing o+ in+lo!s an out+lo!s, an lo! reserves o+ cash"
The risk o+ this situation evelo-ing $ay #e reuce #y o++ering li$ite
creit ter$s to custo$ers, an #y $anaging cash levels an cash +lo! ti$ing
as a se-arate issue +ro$ the accounting inco$e an e3-ense recors"
110
5.7.13. '(vane ation
Many o+ the ste-s that $ay #e taken to -ost-one or avoi insolvency $ay
only #e availa#le early in the -erio o+ +inancial istress, rather than to!ars
the en o+ the -erio"
2or e3a$-le, a lo!er<cost re-lace$ent $achine $ay #e availa#le to re-lace
an e3isting $achine, !ith elivery availa#le three $onths a+ter -ay$ent !as
$ae"
I+ cash levels !ere su++iciently high to -urchase the alternative $achine, then
the ne! $achine coul #e -urchase, an the ol $achine coul #e sol
!hen the ne! $achine arrive"
=o!ever, to!ars the en o+ the -erio, cash reserves $ay #e too lo! to
allo! +or this o-tion"
In this case, the ol $achine $ay have to #e sol +irst, to raise cash to
-urchase the re-lace$ent $achine, an this $ay lea to a three $onth #reak
in -rouction"
Si$ilar issues $ay occur in $any other transactions"
Actions that coul #e taken early in the +inancial istress -erio $ay not #e
-ractical !hen cash levels #eco$e lo! or !hen ti$e -erios #eco$e short"
As another e3a$-le, the ti$e elay involve #et!een $aking a ecision to
sell a $a9or -hysical asset, an actually receiving the -rocees +ro$ the sale,
$ay involve $any $onths"
I+ this ste- is -ost-one until late in the -erio, the cash $ay arrive a+ter the
insolvency ha alreay occurre, an the #usiness o-eration ha alreay
close"
To avoi these risks, action $ay nee to #e taken early in a +inancial istress
-erio, !hile alternatives are still availa#le"
5.7.14. +onserving as. balanes
In general, in a situation o+ +inancial istress, cash #alances shoul #e
-reserve !herever -ossi#le"
111
7iviens are usually cancelle in these circu$stances"
7e#t shoul not #e re-ai until it is clear that the co$-any is in a secure
-osition"
Ance e#t has #een re-ai, it $ay not #e -ossi#le to re<ra! the +uns ue to
the +inancial -osition o+ the #usiness"
Although there $ay #e a slight loss ue to the i++erence in interest rates on
the e#t an the cash holings, this $ay #e $inor in relation to the nee to
have the cash availa#le to $eet e3-enses as they occur"
5.7.15. /uture (iretions
Dhen the short<ter$ -osition o+ the co$-any has #een sta#ilise, action $ay
#e neee to ensure the long<ter$ survival o+ the #usiness"
Many o+ the +inancial istress o-tions can only #e use once"
I+ the situation reoccurs, these o-tions $ay not #e availa#le an the co$-any
$ay #e li&uiate"
The ste-s taken to -ost-one insolvency $ay -rovie a short<ter$ !ino! o+
o--ortunity to restructure the #usiness into a via#le o-eration"
I+ action is not taken uring this -erio, then insolvency $ay #eco$e
inevita#le"
Action $ay involve a co$-lete revie! o+ the #usiness, incluing the
-roucts it -rouces, the $arkets it o-erates in, the +inancial structure o+ the
#usiness, an the si@e an structure o+ e3-enses"
The ai$ +ro$ this e3ercise !oul #e to create a #usiness o-eration that !as
sustaina#le on a long ter$ #asis"
The o--ortunity +or rastic change $ay still #e very li$ite"
=o!ever, eter$ining a clear irection to!ars a sustaina#le structure $ay
#e su++icient to -revent insolvency occurring an to ensure a via#le +uture +or
the #usiness"
112
#.-. 5loating a company
:2loating; a co$-any involves selling the shares o+ the co$-any to a large
nu$#er o+ investors +ro$ the general -u#lic"
:,isting; a co$-any involves registering the shares +or traing through a
stock e3change"
These t!o ste-s are generally -er+or$e as a single -rocess, although there
are a s$all nu$#er o+ !iely<hel -u#lic co$-anies in !hich the shares are
not liste +or traing on a stock e3change
5.8.1. ,easons for floating
There are t!o $ain reasons !hy a co$-any $ay #e +loate"
The #usiness o!ners $ay !ish to e3it the #usiness"
This $ay occur in the case o+ retire$ent, or !hen the #usiness o!ner or
o!ners !ish to !ithra! +ro$ the #usiness o-eration +or one reason or
another"
Also, co$-anies are +loate in orer to o#tain easier access to e&uity ca-ital"
Sourcing aitional e&uity +uns in a -rivate #usiness o-eration $ay #e a
i++icult task"
In these situations, a ne! investor $ust #e -ersonally locate"
Also, this ste- $ay have i$-lications +or the control an evelo-$ent o+ the
#usiness"
Rasing e&uity #y irectly locating -otential investors generally #eco$es
i$-ractical once a co$-any reaches a certain si@e"
In contrast to irect invest$ent, raising e&uity +or a liste -u#lic co$-any is
a relatively straight+or!ar -rocess
A :rights issue; $ay #e conucte, o++ering e3isting shareholers the
o--ortunity to su#scri#e aitional +uns +or ne! shares in the co$-any"
These rights $ay o+ten #e sol, an other investors coul -urchase the rights
an su#scri#e +or the shares"
113
The cash that is su#scri#e #eco$es -art o+ the co$-anyCs assets, an is
availa#le +or -ur-oses such as e3-aning the #usiness o-eration, or
constructing ne! +acilities"
This ste- generally has +e! i$-lications +or the control an o-eration o+ the
#usiness"
Both #e+ore an a+ter an e&uity raising, the shares are generally s-rea
#et!een a large nu$#er o+ investors"
5.8.2. +ontrol strutures after a float
In cases !here the +loat is conucte to ena#le easier access to ca-ital, the
original #usiness o!ner $ay re$ain in the -osition o+ chie+ e3ecutive an
continue to o-erate the #usiness"
In this case, the original #usiness o!ner !oul generally retain a su#stantial
-ortion o+ the shares, although this !oul generally re-resent less than *0L
o+ the co$-any"
In other cases, the #usiness o!ner $ay !ithra! +ro$ active involve$ent in
the #usiness, an $ay retain a su#stantial -ortion o+ the shares as a -assive
invest$ent, or $ay sell the entire co$-any through the +loat"
5.8.3. T.e float an( listing proess
2loating a co$-any is a $a9or -rocess, an $ay involve consiera#le
e3-ense"
As a general rule, a #usiness $ay nee to have revenues o+ several $illion
ollars -er year in orer +or +loating to #e a -ractical o-tion"
=o!ever, +loating $ay #e a natural ste- in the evelo-$ent o+ a #usiness,
an $ost large #usiness enter-rises are liste co$-anies"
The +loat -rocess is generally $anage #y an invest$ent #ank or stock
#roker"
110
The -arty $anaging the +loat $ay avise on the -ricing o+ the shares, assist
in the -re-aration o+ a -ros-ectus, contact -otential investors, an -rovie an
uner!riting service +or the +loat"
Hner!riting a +loat involves an agree$ent to -urchase -art o+ the shares in
the co$-any irectly, i+ insu++icient a--lications are receive +ro$ the
general -u#lic"
A +ee $ay #e charge +or the uner!riting service, the shares $ay #e
-urchase at a iscount, an a su#<uner!riting arrange$ent $ay #e use
!ith $a9or institutional investors to trans+er shares to investors i+ the +loat is
unersu#scri#e"
The +loat -rocess involves -re-aring a ocu$ent kno!n as a :-ros-ectus;"
A -ros-ectus inclues a +ull set o+ auite accounts, an a etaile
escri-tion o+ the #usiness"
The -rocess +or +loating an listing a co$-any is regulate #y a etaile set
o+ regulations in the co$$ercial la!, !hich inclues regulations +or the ste-s
involve in the -rocess, the ti$e +ra$es, an in+or$ation that $ay #e
re&uire, such as a -ros-ectus"
The -ros-ectus $ust generally #e loge !ith a govern$ent regulator an a
stock e3change, i+ a--lica#le"
/o-ies o+ the -ros-ectus $ay #e istri#ute to the -u#lic, an #rokers $ay
istri#ute -ros-ectuses to their clients"
The sale o++er then re$ains o-en +or a -erio o+ ti$e"
Investors !ishing to invest in the co$-any $ay co$-lete the a--lication
+or$ in the -ros-ectus, an sen the a--lication +or$ together !ith a che&ue
to the -arty that is $anaging the +loat"
At the en o+ the o++er -erio, the +loat $ay #e oversu#scri#e or
unersu#scri#e"
I+ too $any a--lications have #een receive, then each investor $ay receive
only -art o+ the share allocation that they re&ueste, an e3cess $oney !oul
#e re+une"
I+ insu++icient a--lications !ere receive, then the +loat $ay #e cancelle, or
the invest$ent #ank or stock #roker $ay -urchase the aitional shares
irectly"
11*
The shares $ay generally #e liste +or traing on a stock e3change a short
ti$e a+ter the o++er closes"
#... Business start9ups
5.9.1. T.e (eision to start a business
%very ti$e an iniviual #uys or sells so$ething, they are conucting a
co$$ercial transaction"
Being e$-loye as an e$-loyee or a contractor is a co$$ercial arrange$ent
#et!een the iniviual an the e$-loyer"
%ach -erson in this situation coul #e consiere to #e running their o!n
-ersonal #usiness"
=o!ever, although these arrange$ents are all co$$ercial transactions, they
are not usually consiere #usinesses in the traitional sense"
Starting a #usiness is not +or everyone"
A-erating a #usiness $ay involve great uncertainty a#out the +uture"
Also, running a #usiness $ay involve a consiera#le in-ut o+ -ersonal energy
an resources"
5.9.2. ,is6s 5it. a start*up enterprise
Although a ne! #usiness enter-rise $ay o++er $any -ossi#ilities, a realistic
outlook $ay also #e neee"
In so$e cases, #usinesses -rouce strong -ositive cash +lo!s over long
-erios o+ ti$e, an accu$ulate signi+icant assets"
=o!ever, this is a co$-aratively rare situation"
A #usiness $ay recor a -erio o+ strong cash +lo!, +ollo!e #y long -erios
o+ lean o-eration !ith li$ite sales an negative cash +lo!"
11)
Dhen a success+ul #usiness o-eration oes evelo-, this is usually the result
o+ reinvesting consiera#le e++orts over a long -erio o+ ti$e"
(reat e++orts $ay also #e e3tene !ithout #ene+its +lo!ing through"
This $ay #e ue to e3ternal events that are #eyon the control o+ the
#usiness, or it $ay #e ue to $is<irecte e++orts, such as evelo-ing a
-rouct +or !hich there is no real unerlying e$an"
A large -ro-ortion o+ atte$-te #usiness start<u-s are unsuccess+ul"
2or e3a$-le, #y so$e esti$ates, 10L o+ ne! restaurants that are o-ene are
unsuccess+ul an eventually close"
Hnsuccess+ul o-erations $ay continue +or a -erio o+ ti$e an then close, or
they $ay o-erate +or long -erios, graually consu$ing the -ersonal assets
an resources o+ the #usiness o-erator"
In other situations, a #usiness $ay o-erate at a -er$anent su#sistence level"
2or e3a$-le, one esti$ate hols that i+ the #usiness o-erators o+ s$all
enter-rises !ere to ra! a ty-ical salary +ro$ the #usiness, u- to hal+ o+ all
s$all enter-rises !oul #eco$e insolvent"
In these cases, the #usiness #eco$es a !ay o+ earning inco$e irectly +ro$
-ersonal actions, #ut in a i++erent +or$ to other a--roaches"
In $any cases, the investors in a ne! #usiness enter-rise $ust contri#ute
their entire assets to the creation o+ the #usiness in orer to raise enough
ca-ital to esta#lish the enter-rise"
This is not a ecision that !oul generally #e taken lightly"
Most start<u-s involve an initial -erio o+ ca-ital e3-eniture an negative
cash +lo!, $eaning that the #usiness $ay #e certain to loose a -ro-ortion o+
the initial +uns, ho!ever the in+lo! o+ +uns +ro$ custo$ers or clients $ay
or $ay not occur"
5.9.3. +on(itions for starting a business
4e! #usiness ventures are so$eti$es +or$e !hen a -erson or a grou- o+
-eo-le see an o--ortunity to evelo- a -rouct or a service, an +eel that the
ti$e it right to co$$ence a #usiness activity"
118
This $ay occur !ith several -eo-le !orking in the sa$e inustry, !ho +or$
a ne! enter-rise an evelo- a ne! -rouct or service"
In other cases, a #usiness venture $ay #egin as a s$all activity an graually
e3-an over ti$e to #eco$e a +ull<ti$e #usiness"
5.9.4. T$pes of start*up
Start<u- enter-rises $ay +all into t!o categories"
So$e #usiness start<u-s are +une !ith -ersonal resources, an -ossi#ly
!ith invest$ents +ro$ relatives an associates"
Ather start<u-s $ay involve larger su$s o+ ca-ital than the +uns that $ay #e
source +ro$ iniviual resources"

2uns +or a start<u- o+ this ty-e $ay #e raise in a -u#lic +loat, or +uns $ay
#e investe #y an e3isting #usiness in a ne! enter-rise"
5.9.5. /un(ing a start*up
5.9.5.1. /un(ing a personal start*up
A#taining +uning $ay #e a i++icult -art o+ the #usiness start<u- -rocess"
In so$e cases an iniviual $ay have -ersonal resources an #e a#le to +un
a start<u- #usiness irectly"
Ather sources o+ +uning $ay inclue #ank loans, taken out as -ersonal
+inancing as an iniviual"
In so$e cases, relatives or associates $ay invest in the enter-rise either
through a loan, or through an e&uity invest$ent"
In the case o+ e&uity invest$ent, the investors $ay take an active -art in
$anaging the enter-rise, or they $ay #e -assive investors an not #eco$e
involve in the -lanning an $anage$ent o+ the enter-rise"
5ersonal +uning $ay occur in the +or$ation o+ #usinesses such as retail
sho-s, restaurants, s$all $anu+acturing o-erations, an service #usinesses"
111
5.9.5.2. /un(ing a larger start*up
A larger start<u- $ay involve raising a large su$ o+ ca-ital, that cannot #e
raise irectly +ro$ iniviual investors"
There $ay #e several -ossi#le sources +or +uns in these situations"
Prospectus issues
The #usiness o-erators $ay +or$ a co$-any, issue a -ros-ectus, an atte$-t
to raise $oney irectly +ro$ the -u#lic"
This -rocess $ay #e -ractical in so$e o+ the +ollo!ing circu$stances"
/o$$encing o-erations in a ra-ily e3-aning inustry"
/o$$encing o-erations uring #oo$ conitions o+ activity"
Dhere the -arties +or$ing the #usiness have su#stantial
e3-erience an -ro+ile !ithin an inustry"
Dhere the ne! #usiness o-eration has access to a ne!
invention or technology"
,arger scale start<u-s so$eti$es occur in high gro!th inustries, -articularly
uring #oo$ ti$es"
enture capital
Another source o+ +uning is kno!n as venture ca-ital"
This +uning is -rovie #y invest$ent +uns that s-ecialise in $aking irect
e&uity invest$ents in -rivate #usiness o-erations"
=o!ever, venture ca-ital is $ost o+ten investe in #usinesses that have
alreay esta#lishe a success+ul o-eration, an are seeking +uns in orer to
e3-an in the si@e o+ the #usiness activity"
116
(%isting "usinesses

Another -ossi#le source o+ +uning $ay co$e +ro$ e3isting #usiness
o-erations"

2or e3a$-le, the #usiness o-erators $ay have !orke !ithin an inustry +or
an e3tene -erio o+ ti$e"

Through associations !ith iniviuals an organisations !ithin the inustry,
the #usiness o-erators $ay #e a#le to locate an organisation that is intereste
in +uning a start<u- o-eration, or is !illing to -rovie ca-ital to invest in a
9oint venture arrange$ent"
In these cases, a strong case $ay nee to #e $ae to o#tain co$$ercial start<
u- +uning +or a ne! enter-rise"
2or e3a$-le, the grou- $ay have evelo-e so$e uni&ue technology, an
$ay then seek +uning to co$$ercialise the technology"
5.9.5.3. Business*fun(e( start*ups
%3isting #usinesses $ay also create start<u- o-erations in certain
circu$stances"
This $ay occur !hen the #usiness ecies to enter a co$-letely ne! $arket"
2or e3a$-le, a $ining co$-any $ay ecie to esta#lish a #usiness in a high<
gro!th inustry such as ata services"
In these cases, an ine-enent o-eration +ro$ the e3isting #usiness $ay #e
esta#lishe"
The e3isting #usiness $ay -rovie +uning, either as a lu$- su$ o+ ca-ital,
or as an ongoing cash +lo! until the ne! o-eration reaches a #reak<even
-osition"
A large o-eration $ay #e esta#lishe in a short s-ace o+ ti$e, incluing
creating an entire organisational structure, hiring e$-loyees, an evelo-ing
-roucts an a $arketing -lan"
A start<u- $ay -lace a consiera#le rain on the resources o+ the #usiness,
an $ay or $ay not #e success+ul"
120
5.9.!. T.e business onept
Starting a #usiness $ay involve evelo-ing a ne! -rouct or service, or it
$ay involve co$$encing a traitional #usiness o-eration !ithin an
esta#lishe inustry"
4e! ieas $ay -articularly a--ly to situations !here the #usiness o!ners
have !orke !ithin an inustry +or an e3tene -erio o+ ti$e, an have
seen the nee +or a -rouct or service that is not currently availa#le"
A -ossi#le #ene+it o+ this situation is that there $ay #e a strong an
i$$eiate e$an +or the -rouct or service once it is evelo-e an
launche"
=o!ever, they $ay also #e a range o+ isavantages !ith co$$encing a
#usiness #ase on a ne! iea"
Su--lies $ay not #e reaily availa#le, ne! e&ui-$ent an $anu+acturing
-rocesses $ay nee to #e evelo-e, an an e3tene -erio o+ ti$e $ay #e
involve #e+ore the -rouct or service is availa#le in sustaina#le volu$es"
Sales volu$es o+ the -rouct $ay #e i++icult to esti$ate, as there $ay #e no
esta#lishe sales -attern to use as a +ra$e o+ re+erence"
Although in so$e cases the e$an +or the -rouct $ay #e i$$eiate, in
other cases a long elay $ay #e involve in evelo-ing sustaina#le sales
volu$es, ue to the nee +or -otential custo$ers to #eco$e +a$iliar !ith the
-rouct"
%sta#lishing a #usiness as a traitional o-eration $ay also have avantages
an isavantages as an a--roach to co$$encing a #usiness o-eration"
Su--lies $ay #e reaily availa#le, techni&ues +or -roucing the -rouct $ay
#e !ell esta#lishe, an it $ay #e -ossi#le to esta#lish a +ully o-erational
#usiness !ithin a short -erio o+ ti$e"
=o!ever, $ost inustries o-erate on a co$-etitive #asis, !ith -rices +alling
to the lo!est sustaina#le levels, #ase on the unerlying costs involve in
o-erating the #usiness activity"
In this situation, it $ay #e i++icult +or ne! #usinesses to esta#lish a
-ro+ita#le an e3-aning o-eration"
121
The level o+ -rices $ay #e eter$ine #y the costs an -ricing o+
e3-erience o-erators !ith esta#lishe +acilities an custo$er #ases"
In o++ering si$ilar -rice levels, a ne! #usiness $ay have insu++icient net cash
+lo! to invest in ne! evelo-$ents, $arketing -rogra$s, an so on"
In general, a higher level o+ -ro+it an cash +lo! $ay #e neee to e3-an a
#usiness than to $aintain an e3isting level o+ #usiness activity"
=o!ever, esta#lishing a traitional #usiness $ay have the avantage that an
e3isting $arket +or the -rouct or service $ay #e active"
%sta#lishing a traitional o-eration $ay #e -articularly relevant !ithin
inustries !here each #usiness services a li$ite geogra-hic area, such as
retail o-erations"
5.9.7. Testing a business onept
Starting a ne! #usiness $ay #e a large ste-"
This $ay involve the #usiness o!ners contri#uting a large -ro-ortion o+ their
assets, an a consiera#le a$ount o+ energy an e++ort, in atte$-ting to
esta#lish a #usiness enter-rise"
In the case o+ a +aile start<u- atte$-t, a large -ro-ortion o+ the #usiness
o!nerCs assets $ay #e lost"
Also, a great eal o+ ti$e an e++ort $ay #e s-ent on a -rocess that $ay
eventually #e a#anone, ue to insolvency, or ue to the inco$e +ro$ the
enter-rise #eing insu++icient to cover costs an $aintain a sustaina#le
o-eration"
Dhere -ossi#le, every e++ort shoul generally #e $ae to ensure that the
#usiness has a reasona#le chance o+ success, #e+ore the ecision is $ae to
atte$-t the esta#lish$ent -rocess"
A nu$#er o+ ste-s $ay #e taken to test the conce-t on !hich the #usiness
!ill #e #uilt"
In the case o+ -hysical -roucts, sa$-les coul #e -rouce an istri#ute
to -otential custo$ers, #e+ore $a9or e&ui-$ent -urchases !ere $ae an
-re$ises !ere rente"
122
This $ay allo! the $arket e$an +or the -rouct to #e teste, #e+ore $a9or
e3-enses !ere incurre"
Although iscussions !ith -otential custo$ers an clients $ay #e use+ul in
so$e circu$stances, actually su--lying the -rouct or service $ay #e
necessary in orer to eter$ine the sustaina#le interest in the -rouct"
In so$e cases, s$all volu$es o+ the -rouct or service coul #e -rouce, to
gauge $arket interest, to eter$ine -rice levels that coul #e sustaine, an
to solve teething -ro#le$s"
This $ay initially #e one on a loss<$aking #asis, !ith -roucts #eing sol
at their target +inal -rice, rather than -rices #eing eter$ine #y costs"
In the case o+ a success+ul +lo! o+ sales, a ecision $ay #e $ae to atte$-t
to esta#lish the +ull #usiness o-eration"
5.9.8. Developing a business plan
Several $a9or ste-s $ay #e involve in +or$ing a ne! enter-rise"
2irst, there $ust #e an iea, irection or conce-t #ehin the enter-rise"
This $ay si$-ly #e a esire to o-erate a traitional #usiness o+ one +or$ or
another, or it $ay #e a res-onse to an o--ortunity +or a ne! -rouct or
service that is $issing +ro$ an inustry an $ay $eet !ith a strong e$an"
/o$$encing a #usiness activity $ay involve initially evelo-ing a #usiness
-lan"

The #usiness -lan $ay inclue so$e o+ the +ollo!ing in+or$ationE
The iea, -ur-ose, -rouct or service that the #usiness enter-rise
!ill #e #uilt on"
A ti$e +ra$e +or each stage o+ the #usiness evelo-$ent, incluing
+or$ing the enter-rise, evelo-ing sa$-le -roucts, a target ate to
co$$ence -rouction or su--lying services, an a target ate +or a
#reak<even cash +lo!"
These ti$e -erios $ay #e +airly general"
123
Ane e3a$-le $ay #e three $onths to +or$ the enter-rise, such as
renting o++ice s-ace an arranging registrations, three $onths
-roucing sa$-le -roucts an e$onstrating services, actual
-rouction to co$$ence in si3 $onthCs ti$e, an #reak<even cash
+lo! to occur in eighteen $onthCs ti$e"
A #uget +or all e3-enses, u- until the target ate o+ #reak<even cash
+lo!"
A +uning -lan, such as a list o+ a$ounts to #e contri#ute #y each
-arty that !ill #e investing +uns in the enter-rise"
A long<ter$ irection, such as a #roa irection +or the #usiness to
take over the ne3t +ive years"
A -lan +or ecision<$aking, control o+ the #usiness, an resolving
is-utes" 2or e3a$-le, an agree$ent $ay #e $ae to +or$ a
co$-any structure, !ith each +ull<ti$e -artici-ant in the enter-rise
#eing a irector o+ the co$-any"
A -lan +or e3iting the #usiness i+ the venture is not success+ul or i+
one o+ the -artici-ants !ishes to !ithra! +ro$ the enter-rise"
A--eni3 A, #eginning on -age 10)8 contains an e3a$-le o+ a #usiness -lan
+or a start<u- enter-rise"
The issues involve in o-erating the #usiness $ay nee to #e #rought
+or!ar an iscusse o-enly #e+ore the enter-rise co$$ences"
This -rocess $ay continue until the issues have #een +ully !orke through
an all the -ossi#le scenarios have #een consiere"
Business ventures $ay egenerate into #itter struggles an isagree$ents"
Ance a is-ute or a -ro#le$ has arisen, it $ay #e too late +or iscussions to
#e use as a !ay o+ reaching agree$ent as to the $a9or irection o+ the
#usiness, or the $ethos to #e use +or o-erating the #usiness"
120
5.9.9. 4nitial p.ase
7uring the initial stage o+ the #usiness, cash +lo! $ay #e negative"
4egative cash +lo! $ay continue +or as long as several years in so$e cases"
In this situation, the cash +lo!ing out o+ the #usiness in e3-enses an ca-ital
-urchases $ay #e larger than any inco$e receive +ro$ custo$ers or clients"
Several o-tions $ay e3ist in ter$s o+ -ersonal inco$e +or the #usiness
o-erators uring this ti$e"
In so$e cases it $ay #e +easi#le +or the #usiness o-erators to live +ro$
-ersonal resources, using either -ersonal assets or inco$e +ro$ other +a$ily
$e$#ers"
In other cases, a +ull<ti$e or -art ti$e 9o# $ay #e retaine uring the initial
-hase, in aition to conucting the #usiness o-erations"
Another o-tion $ay #e to ra! a salary +ro$ the start<u- +uns o+ the
enter-rise"
This $ay re&uire a signi+icantly larger ca-ital invest$ent than the +uns
neee to -urchase o++ice e&ui-$ent or ra! $aterials"
In this +uning !as availa#le, then the initial ca-ital !oul #e raise at the
#eginning o+ the enter-rise, an the e3-ense #uget !oul inclue salaries
+or the #usiness o-erators, !hich !oul #e ra! +ro$ the ca-ital invest$ent"
5.9.1". +ommening operations
2le3i#ility an steay +or!ar -rogress $ay #e i$-ortant uring the initial
-erio"
In the case o+ negative cash +lo!, the assets o+ the #usiness steaily ecline"
This -laces the #usiness on a li$ite ti$e +ra$e, until the cash reserves are
e3hauste an the #usiness #eco$es insolvent"
Steay +or!ar -rogress $ay #e necessary uring this ti$e to ensure that a
sustaina#le o-eration is create #e+ore the availa#le +uns +all to @ero"
12*
Initial ieas $ay turn out to #e i$-ractical, an signi+icant changes in
irection $ay #e neee"
7uring this -erio the situation $ay #e very +lui, an the goal $ay #e to
+in a !ay to esta#lish a via#le #usiness o-eration that !oul -rouce
-rouces or services that $et !ith a e$an +ro$ custo$ers"
5.9.11. Developing a lient base
Dhen -rouction +acilities have #een evelo-e an the #usiness o-eration
has #een +or$e, the ne3t ste- $ay involve a $a9or $arketing -hase"
This $ay involve irecting the resources o+ the #usiness to!ars $arketing
activities, to evelo- an esta#lishe custo$er or client #ase, an to evelo- a
sustaina#le level o+ sales"
Marketing activities $ay inclue a--roaching -otential clients, avertising,
an -roucing -ro$otional $aterial to su--ort the esta#lish$ent o+ a client
or custo$er #ase"
5.9.12. Brea6*even as. flo5
I+ the initial $arketing -hase !as success+ul, a gro!th in sales $ay result in a
#reak<even cash +lo! occurring, assu$ing that -rices ha #een set to a level
that !as su++icient to cover costs an generate a -ro+it"
5assing the #reak<even cash +lo! stage $ay #e a $a9or $ilestone"
In the case o+ -ositive cash +lo!, although the +uture $ay #e uncertain, a
+i3e ti$e +ra$e until insolvency oes not e3ist"
5ositive cash +lo! $ay then allo! the #usiness to evelo- !ith a steay
inco$e an -ossi#ly o--ortunities +or +uture gro!th
Technically, non<cash e3-enses such as e-reciation are inclue in
eter$ining a #reak<even -ro+it level"
2or e3a$-le, a #usiness $ay have -ositive cash +lo!, #ut still involve a
ecline in net assets an an unsustaina#le o-eration i+ the e-reciation o+
e&ui-$ent is larger than the cash in+lo!"
12)
In -ractice, ho!ever, crossing the -oint o+ -ositive cash +lo! $ay #e the
$a9or ste- in ensuring a via#le o-eration +or the #usiness in the $eiu$ an
long ter$"
5.9.13. Burn rates an( negative as. flo5
A ty-ical -attern !ithin a #oo$ -erio in a high gro!th inustry $ay involve
an iniviual or s$all grou- raising a su$ o+ ca-ital through a -u#lic +loat,
hiring e$-loyees an -urchasing e&ui-$ent, an then atte$-ting to create
-roucts an #uil a client #ase"
This situation $ay lea to high negative cash +lo!s, !ith the original ca-ital
only su--orting the o-erations +or a li$ite -erio o+ ti$e"
This -attern $ay also #e co$$on in the $ining inustry, !here ca-ital $ay
#e raise #y s$all co$-anies, !ith geological surveys #eing conucte in an
atte$-t to locate an ore #oy +or $ining"
The level o+ negative cash +lo! is kno!n as the #urn rate"
The nu$#er o+ $onths re$aining until the availa#le ca-ital is consu$e can
#e calculate using the +ollo!ing +or$ulaE
outflo( monthly net
capital available
remaining months
2or e3a$-le, an o-eration !ith a net cash out+lo! o+ G* -er $onth an G*1
o+ availa#le ca-ital $ay have the +ollo!ing -erio o+ ti$e re$aining until the
ca-ital !as e3hauste"
*
*1
remaining months
months .) 11
128
In this e3a$-le, the #usiness !oul #e a#le to continue o-erating +or another
eleven $onths at the current rate o+ cash out+lo!"
I+ the #urn rate continue at this level +or the +ull -erio, the #usiness $ay
atte$-t to raise aitional ca-ital, other!ise it !oul #e una#le to continue
o-erating an o-erations !oul cease"
In the case o+ start<u-s uring #oo$ ti$es, it is co$$on +or a co$-any to
raise aitional ca-ital +ro$ investors several ti$es #e+ore reaching a #reak<
even cash +lo! -osition"
/a-ital raisings $ay #e se-arate #y ti$e -erios ranging +ro$ si3 $onths to
several years in these cases"
=o!ever, in the case o+ a start<u- +une #y -ersonal resources, this o-tion
$ay not #e availa#le, an a single o--ortunity $ay e3ist to esta#lish a
-ositive cash +lo! o-eration"
#.10. 1aluation
A 'aluation -rocess $ay #e use to esti$ate the value o+ an asset"
'aluations $ay #e use +or so$e o+ the +ollo!ing -ur-oses"
5re-aring a #alance sheet"
Assessing an asset that !ill #e use as security +or a #ank loan"
7eter$ining a sale -rice +or an asset"
7eter$ining !hether to -urchase an asset that is o++ere +or sale"
2una$entally, the value o+ an asset $ay #e #ase on the inco$e that coul
#e receive +ro$ the asset"
This $ay involve a sale -rice in the case o+ selling the asset, or a +uture
inco$e strea$ in the case o+ so$e intangi#le assets such as a #usiness #ran
na$e"
121
5.1".1. T$pes of value
7i++erent values $ay #e -lace on an asset in i++erent circu$stances"
This $ay inclue so$e o+ the +ollo!ing ty-es o+ value"
/arket value
The $arket value o+ an asset is the -rice that coul #e receive i+ the ite$
!as o++ere +or sale in an o-en $arket"
In this res-ect, the value o+ an asset is the a$ount that so$eone else !oul
#e !illing to -ay to -urchase it"
Market value is the value that is use in $ost circu$stances, such as !hen
eciing !hether to #uy or sell an asset, an +or the -ur-oses o+ security +or
lening -ur-oses"
1perational value
The o-erational value o+ an asset is the value o+ the asset !ithin the #usiness
o-erations"
This $ay involve the +uture inco$e that $ay #e erive +ro$ the asset"
An asset $ay have an o-erational value to the #usiness that $ay #e i++erent
+ro$ its $arket value"
2or e3a$-le, -artly +inishe goos $ay have a signi+icant value to the
#usiness, -articularly +or large ite$s o+ e&ui-$ent"
In the course o+ nor$al o-erations, -artly +inishe goos !oul #e co$-lete
an sol to generate inco$e +or the #usiness"
=o!ever, the $arket value o+ a -artly co$-lete ite$ o+ e&ui-$ent $ay #e
close to @ero"
Book value
Book value is the value that is recore in the #alance sheet +or an asset"
Traitionally, accounting is not irectly concerne !ith $arket values"
126
2or e3a$-le, a $achine $ay #e -urchase +or a -rice o+ G100, an have a
use+ul li+e o+ +ive years"
Hsing straight<line e-reciation, this !oul #e recore !ith a #ook value o+
G10 at the en o+ the +irst year, G)0 at the en o+ the secon year, then G00,
G20, an +inally @ero at the en o+ the +i+th year"
The e-reciation a--roach is a $etho o+ allocating the cost o+ the
e&ui-$ent over the use+ul li+e o+ the e&ui-$ent"
This allo!s the cost in each -erio to #e $atche to the inco$e -rouce in
the -erio"
=o!ever, the #ook value that is recore in the #alance sheet $ay not $atch
the $arket value o+ the e&ui-$ent"
In cases !here the rate o+ e-reciation is a--ro3i$ately e&ual to the ecline
in the $arket value o+ the e&ui-$ent, the #ook value $ay #e si$ilar to the
$arket value"
In other cases, the values $ay #e &uite i++erent
Li)uidation value
,i&uiation value is the value that coul #e receive i+ the ite$ !as sol"
This is a si$ilar conce-t to $arket value, although the ter$ $ay #e use +or
ite$s such as stock !hich !oul not nor$ally #e sol irectly, an !oul
not #e classi+ie as having a $arket value"
Also, in the case o+ so$e large ite$s, the value that coul #e realise +ro$ a
sale $ay not $atch the -otential value o+ the sale o+ si$ilar ite$s"
2or e3a$-le, a large #lock o+ shares that !as hel #y the original #usiness
o!ners $ay #e value using the current share -rice"
=o!ever, to sell the entire #lock, a #roker $ay nee to locate institutional
investors !ho !ere -re-are to -urchase large -arcels o+ the shares, an a
iscount $ay #e re&uire to ena#le a transaction to go through"
In the case o+ selling a s$all -art o+ the holing, ho!ever, the +ull $arket
-rice $ay #e receive"
130
A si$ilar -ro#le$ $ay arise !ith the sale o+ large co$$ercial o++ice
#uilings"
The li&uiation value inclues the -enalty or iscount that !oul #e re&uire
to create a -articular transaction, !hile the $arket value $easures the sale
value o+ si$ilar ite$s"
So$e assets $ay have a value to the #usiness, #ut cannot #e sol"
2or e3a$-le, the e3cess -rice -ai a#ove the net asset value +or -urchasing a
#usiness is recore in the #alance sheet as an asset, on the #asis that the
e3cess -rice !oul #e -ai +or so$e +uture #ene+it to the #usiness"
=o!ever, this is an intangi#le asset that has no #ene+it +or other -arties an
coul not #e sol"
Ather assets $ay cease to have a value i+ the #usiness is li&uiate"
A :+uture inco$e ta3 #ene+it; an ta3 losses +ro$ -revious years $ay +all
into this category"
These ite$s !oul #e #ene+icial to the #usiness in +uture years i+ o-erations
continue, ho!ever they have no value in the event o+ a li&uiation"
$ealisa"le value
The realisa#le value re-resents the cash that coul #e raise +ro$ selling the
asset"
This value is #ase on the li&uiation value o+ the asset, #eing the $arket
value o+ the asset less the iscount that $ay #e involve in conucting a large
transaction at short notice"
=o!ever, the realisa#le value also inclues any transaction costs that $ay #e
involve in conucting the sale -rocess"
131
5.1".1.1.#ummar$ of valuation figures
Market value The sale -rice that an asset $ay receive in an o-en
$arket"
A-erational value The value o+ an asset to the #usiness, in ter$s o+ the
inco$e that coul #e receive #y the #usiness ue to
the asset"
Book value The accounting recor o+ the value o+ an asset, #ase
on allocating the cost o+ the asset across its use+ul
!orking li+e"
,i&uiation value The sale -rice o+ an asset, less any loss ue to the
e++ect o+ traing a large asset !ithin a short -erio o+
ti$e"
Realisa#le value The value o+ the cash that coul #e raise +ro$ selling
the asset, #ase on the $arket -rice, less a iscount to
ena#le a transaction to occur, less the transaction costs"
5.1".2. T$pes of asset
'aluations $ay #e -er+or$e on -ro-erties, #usinesses, -ro9ects, -rouction
+acilities, #ran na$es, -atents, an al$ost anything that can #e #ought, sol,
or $ay result in +uture inco$e to the #usiness"
5.1".3. Obtaining a valuation
In so$e cases, a esti$ate o+ the value o+ an asset $ay #e eter$ine +ro$
recent sales o+ si$ilar ite$s, or #y -er+or$ing a calculation #ase on a
valuation $ulti-le"
'aluations are also -er+or$e #y s-ecialist valuation +ir$s"
'aluations are availa#le +or -ro-erties o+ all kins, +or #usinesses, an +or
intangi#le assets such as #ran na$es"
'aluations $ay #e cost<e++ective an $ay #e an i$-ortant -art o+ -urchasing
a -ro-erty or a #usiness"
132
'aluations are +re&uently re&uire #y leners such as #anks, -rior to
acce-ting an asset as security +or a loan"
5.1".4. :aluation -et.o(s
5.1".4.1.-ar6et Tra(e( :alue
In so$e cases, assets $ay trae in high volu$es, !ith $any assets o+ the
sa$e ty-e #eing trae"
This $ay a--ly to shares, co$$oities such as silver, an any other ite$ that
is sol on a +re&uent #asis"
In these cases, a valuation $ay #e #ase on the -rice o+ the $ost recent trae"
Dhen a :$arket -rice; &uote a--ears in ocu$entation, this generally relates
to the -rice o+ the last trae that !as e3ecute"
In the case o+ assets !ith lo! turnover, i+ a signi+icant -erio o+ ti$e has
-asse since the last trae, the asset $ay#e value at the current #i -rice,
rather than the last sale -rice"
=o!ever, in so$e cases the #i -rice $ay not #e an accurate re+lection o+
$arket value"
A lo! #i $ay #e -oste on the s$all chance o+ the #i #eing +ille, or to
attract o++ers to initiate a #i<o++er $ove to!ars an e3ecution -rice"
5.1".4.2.=et 'sset :alue
In the case o+ valuing a #usiness, the assets o+ the #usiness $ay #e
iniviually value using a range o+ valuation a--roaches"
The total value o+ the assets, less the a$ount o+ outstaning e#ts, $ay then
re-resent the net assets o+ the #usiness"
The net asset +igure $ay #e use as a #ench$ark +or eter$ining a value +or
the #usiness"
4et asset values $ay also #e use in cases such as invest$ent unit trusts"
133
So$e transactions $ay #e conucte !ith the -rice #eing e&ual to the net
asset value"
This situation $ay occur !hen the assets o+ the #usiness $ay #e su#stantial,
an the #usiness $ay not have signi+icant o-erations that $ay a a goo!ill
co$-onent +ro$ on<going o-erations to the #usiness value"
A net asset a--roach $ay also #e use in the case o+ s$all enter-rises, such
as !hen the -revious #usiness o!ner $ay have -er+or$e a signi+icant
-ro-ortion o+ the !ork in the #usiness activity, or !here the #usiness $ay
conuct iniviual sales to a large range o+ custo$ers, an a signi+icant
goo!ill value +ro$ esta#lishe o-erations $ay not e3ist"
In the case o+ so$e loss<$aking an -oorly structure o-erations, or assets in
-oor conition, a #usiness $ay #e value at a iscount to the net asset value"
In the case o+ a sta#le an success+ul #usiness o-eration, a value $ay #e
esti$ate as a -re$iu$ to the net asset value, such as a 20L -re$iu$ to the
value o+ the net assets"
A #usiness $ay also #e sol at a -re$iu$ to the net asset +igure in cases
!here the #usiness activity $ay have a high e3-ecte or -otential gro!th
rate"
5.1".4.3.=et 3resent :alue
A 4et 5resent 'alue or 7iscount /ash +lo! Analysis eter$ines a valuation
+ro$ the +uture cash +lo!s that coul #e generate +ro$ the asset"
2or e3a$-le, a -ro-erty $ay return a net inco$e +ro$ rent $inus e3-enses,
!hile an ite$ o+ e&ui-$ent $ay #e use to -rouce inco$e, less the costs o+
$aintenance an e-reciation"
The section #eginning on -age 820 contains etails o+ the calculations that
$ay #e involve in eter$ining a net -resent value +igure"
5.1".4.3.1. +alulating a net present value
As an e3a$-le, a -iece o+ e&ui-$ent $ay have a li+e s-an o+ ten years, an
$ay return a net inco$e a+ter e3-enses o+ G10 -er year"
130
Hsing a iscount rate o+ 12L, the value o+ this ite$ coul #e eter$ine
using the annuity +or$ula
( )
y
y
payment value present net
n
+

1 1
12 0
12 0 1 1
10
10
.
9 . 7

+

*8 5
In the case o+ a -er-etual inco$e, such as inco$e +ro$ a rental -ro-erty, the
net -resent value #eco$es a si$-le $ulti-le o+ the interest rate, using the
-er-etual annuity +or$ula"
2or e3a$-le, a -ro-erty $ay return a net inco$e a+ter e3-enses o+ G20 -er
year"
Assu$ing a iscount rate o+ 12L, the value o+ the -ro-erty coul #e
calculate using the +ollo!ing e3a$-le"
y
amount
value persent net
12 0
20
.

1)8 5

Dhen a range o+ i++erent cash +lo!s $ay #e involve, such as a
evelo-$ent -ro9ect, the net -resent value can #e eter$ine #y calculating
the -resent value o+ each iniviual cash +lo!, an su$$ing the iniviual
-resent values to eter$ine a total net value +or the asset"
A net -resent value a--roach $ay #e -articularly use+ul +or assets that cannot
#e irectly co$-are to si$ilar assets to esti$ate values, such as
evelo-$ent -ro9ects"
13*
4et -resent values $ay #e use +or valuing -ro9ect cash +lo!s, #usinesses,
an co$$ercial -ro-erties"
The t!o key in-uts to a net -resent value calculation are the esti$ates o+
+uture inco$e, an the iscount rate that is use"
5.1".4.3.2. Estimating future inome
In so$e cases the +uture inco$e $ay #e esti$ate !ith reasona#le accuracy"
This $ay occur !ith long<ter$ -ro-erty leases, an in+rastructure assets such
as toll roas"
In other cases, such as launching a ne! -rouct, it $ay not #e -ossi#le to
accurately esti$ate the likely +uture inco$e"
In these situations, several valuations $ay #e calculate"
2or e3a$-le, #est<case, average<case an !orst<case esti$ates o+ the inco$e
+ro$ a ne! -rouct $ay #e $ae, an three se-arate valuations o+ the -ro9ect
$ay #e calculate"
In this case, an average value o+ several valuation scenarios coul #e use,
or several values coul #e use se-arately in the -lanning -rocess"
5.1".4.3.3. Disount rates
The choice o+ iscount rate $ay e-en on the current level o+ interest rates,
an the risk o+ the -ro9ect"
An aitional a$ount $ay #e ae to a #ase interest rate to allo! +or the
-ro9ect risk, !ith a higher risk -re$iu$ #eing ae +or high risk -ro9ects"
A high iscount rate reuces the value o+ the -ro9ect"
This re+lects the +act that the +uture cash +lo!s $ay not occur, an even i+
they o, there $ay #e a -enalty involve in the +act that the +uture cash +lo!s
are uncertain, an this $ay -revent other actions #eing taken i+ there is a high
level o+ uncertainty involve in the likely value o+ the +uture cash +lo!s"
13)
The choice o+ a iscount rate $ay have a signi+icant i$-act on the valuation,
-articularly +or long<ter$ cash +lo!s"
Risk -re$iu$s $ay #e as lo! at 1L or 2L +or very sta#le cash +lo!s, or as
high as 1*L or 20L +or risky -ro9ects"
2or e3a$-le, a $eiu$ risk -ro9ect $ay #e allocate a risk -re$iu$ o+ )L,
uring a ti$e !hen interest rates are aroun the 1L level"
The rate use in the calculation then !oul #eE
Base rate 1L
Risk -re$iu$ )L
7iscount rate use 10L
The #ase interest rate $ay #e chosen +ro$ a lo!<risk rate, such as a #ank
re+erence rate or a govern$ent #on rate"
7iscount rates are iscusse in the section #eginning on -age 8*6"
5.1".4.4.+omparative :aluation
/o$-arative valuation involves eter$ining a value #ase on recent sales o+
si$ilar ite$s"
This $etho is co$$only use in valuing -ro-erties"
/o$-arative valuation is also use to value so$e #usinesses"
This $ay a--ly in the case o+ s$all enter-rises !here there $ay #e a nu$#er
o+ sales o+ #usinesses o+ si$ilar si@e an o-eration, an in the case o+
consoliating inustries, !here a large nu$#er o+ si$ilar transactions $ay
occur"
/o$-arative valuation re&uires several sales o+ other ite$s, all !ithin a
recent -erio such as the -revious +e! $onths, an all #eing reasona#ly
si$ilar to the asset #eing value"
138
This is only -ractical in cases !here there is a reasona#le volu$e o+ sales in a
range o+ si$ilar ite$s"
The $arket -rice o+ shares coul #e consiere a co$-arative valuation in
so$e res-ects, as the -rice that is usually &uote is actually the -rice o+ the
last trae that occurre in those shares"
5.1".4.5.:aluation -ultiples an( ;iel(s
5.1".4.5.1. -ultiples
A valuation $ay #e eter$ine as a $ulti-le o+ another +igure, such as the
e3-ecte inco$e +ro$ the asset"
In this $etho, the esti$ate value $ay #e calculate using the +ollo!ing
+or$ula"
multiple amount value
2or e3a$-le, the e3-ecte rental inco$e o+ a -ro-erty $ay #e G* -er year,
!ith recent -ro-erty sales occurring at $ulti-les o+ aroun 1 ti$es rental
inco$e"
In this case, the value o+ the -ro-erty coul #e esti$ate using the +ollo!ing
calculation"
1 * value
00 5
'aluation $ulti-les $ay #e use+ul in several conte3ts"
A valuation $ulti-le $ay allo! a +igure such as an average long<ter$ return,
a current interest rate, or a return availa#le on an alternative invest$ent to #e
use to eter$ine a valuation"
131
Also, the use o+ $ulti-les $ay allo! a !ier range o+ asset sales to #e use
as re+erences +or a co$-arative valuation, rather than si$-ly revie!ing sales
o+ si$ilar assets"
Sales o+ assets $ay occur at si$ilar $ulti-les, even though the ollar a$ount
o+ +igures such as inco$e an asset values $ay #e i++erent"
In so$e situations, such as large co$$ercial -ro-erties an -rouction
+acilities, si$ilar assets $ay not e3ist, or the ti$e s-an #et!een sales $ay #e
large, !hich $ay li$it the use+ulness o+ a irect co$-arative valuation
a--roach"
5.1".4.5.2. Determining a multiple
Dhen a $ulti-le is eter$ine +ro$ other sales, the +ollo!ing +or$ula can #e
useE
amount
value sale
multiple
2or e3a$-le, a -ro-erty $ay have an e3-ecte rental inco$e o+ G0 -er year,
an $ay sell +or a -rice o+ G*0"
In this case, the $ulti-le coul #e eter$ine using the +ollo!ing e3a$-le"
amount
value sale
multiple
0
*0

* 12.
In this e3a$-le, the sale -rice o+ the asset re-resente a $ulti-le o+ 12"*
ti$es the e3-ecte rental inco$e"
This calculation coul #e re-eate +or a nu$#er o+ recent sales"
136

As an e3a$-le, this -rocess $ay eter$ine that recent sales o+ si$ilar
-ro-erties ha occurre at $ulti-les o+ aroun 12 ti$es rental inco$e"
In the case o+ a -ro-erty !ith an e3-ecte rental inco$e o+ G* -er year, a
value coul #e esti$ate using the +ollo!ing e3a$-le"
multiple amount value
12 *
)0 5
5.1".4.5.3. :alues of multiples
Assets o+ a si$ilar nature $ay trae at si$ilar $ulti-les"
A $ulti-le $ay vary accoring to the sta#ility or volatility o+ the inco$e
a$ounts an o+ the asset value"
Multi-les $ay also vary !ith the e3-ecte gro!th rate o+ the asset value an
inco$e"
In the case o+ -ro-erties, +or e3a$-le, the $ulti-le $ay e-en on the
e3-ecte ca-ital gro!th in the -ro-erty value"
In the case o+ #usinesses, the $ulti-le $ay e-en on the sta#ility o+ the
#usiness inco$e, an the e3-ecte or -otential gro!th in net -ro+it o+ the
#usiness"
,o! $ulti-les $ay a--ly to volatile inco$e, an lo! gro!th e3-ectations
+or +uture inco$e strea$s an asset values"
=igh $ulti-les $ay a--ly in the case o+ sta#le inco$e strea$s, an in cases
!here the outlook $ay involve rising inco$e levels or ca-ital values +or the
asset"
(>> gro!th -er-etual annuity -lus iscount +or volatility)
100
5.1".4.5.4. #oures of multiples
Multi-les can #e calculate irectly +ro$ sales o+ assets"
Also, $ulti-les $ay #e -u#lishe #y a nu$#er o+ organisations, such as real
estate associations, stock e3changes, an govern$ent e-art$ents"
Multi-les $ay also #e -u#lishe in the #usiness -ress"

2or e3a$-le, the :-rice<earnings; ratio o+ co$-anies $ay #e !iely &uote"
This $ulti-le $easures the ratio o+ a -rice o+ a share o+ the co$-any
earnings -er share"
5.1".4.5.5. -ultiples & ;iel(s
Multi-les $ay #e inverte to eter$ine a -ercentage yiel"
Wiels $ay #e easier to inter-ret in a -ractical sense than $ulti-les, as
+igures such as rental yiels, earnings yiels an so +orth $ay #e irectly
co$-are to interest rates"
/onversions #et!een $ulti-les an yiels $ay #e one using the +ollo!ing
+or$ulas"
yield
multiple
100

multiple
yield
100

2or e3a$-le, a $ulti-le o+ 12 ti$es rental inco$e coul #e converte into a

yiel using the +ollo!ing e3a$-le
multiple
yield
100

101
12
100

.3 1
This inicates that a $ulti-le o+ 12 ti$es inco$e corres-ons to an inco$e
yiel o+ 1"3L"
This +igure re-resents the rental inco$e as a -ercentage o+ the asset value,
an coul #e co$-are to the interest rate on a #ank e-osit"
Wiels an $ulti-les are alternative $ethos o+ e3-ressing the sa$e set o+
+igures"
5.1".4.5.!. T$pes of multiples
'aluation $ulti-les $ay #e use in valuing #usinesses"
So$e $ulti-les that $ay #e use coul inclue the +ollo!ing ite$s
A $ulti-le #ase on earnings (net -ro+it)
A $ulti-le o+ cash +lo!
A $ulti-le o+ net assets
A $ulti-le o+ the nu$#er o+ custo$ers
A $ulti-le o+ sales inco$e
A $ulti-le o+ the transaction +lo! that the #usiness $ay $anage,
such as transaction si@es in a #usiness in !hich the +ees are #ase on
a -ercentage o+ the transaction si@e"
An inustry<s-eci+ic value, such as a -articular value that $ay
ienti+y the si@e o+ an o-eration !ithin a -articular inustry"
In so$e cases several $ulti-les $ay #e use"
102
A valuation coul #e #ase on the average value that !as eter$ine +ro$
each o+ the $ulti-les, or the values coul #e incor-orate !ith other
in+or$ation to esti$ate a value"
'aluation $ulti-les $ay have a #ene+it in ra!ing attention to the key issues
that $ay #e involve in an invest$ent"
7uring ti$es o+ ra-ily rising -rices, a co$-arison !ith other sales $ay not
highlight the unerlying invest$ent issues that $ay #e involve !ith a sale
or -urchase o+ an asset at the current $arket -rice"
5.1".4.!.,ule*of*t.umb valuations
Rule o+ thu$# valuations $ay #e use+ul in a nu$#er o+ circu$stances"
This a--roach $ay involve a #asic calculation, such as using a $ulti-le o+
ten ti$e earnings +or a certain situation, an eter$ining a -rice #y
$ulti-lying the net inco$e #y ten"
Another rule o+ thu$# a--roach $ay a--ly a ratio to the net assets, such as
valuing a -articular ty-e o+ #usiness at a 20L -re$iu$ to the net asset value"
A rule<o+<thu$# a--roach $ay #e use to -lace a transaction in -ers-ective"
In so$e circu$stances, this a--roach $ay #e use to eter$ine !hether a
transaction is -otentially +avoura#le, a #orerline situation, o+ is e+initely
i$-ractical, !ithout the ti$e an e3-ense that $ay #e involve in a +ull
valuation"
A rule o+ thu$# valuation $ay also #e use to veri+y that a valuation is
!ithin a realistic range, in situations such as +inancial state$ents, internal
re-orting, valuations o+ assets +or sale, an -ro9ect -ro-osals"
This $ay highlight situations in !hich o-ti$istic -ro9ections are use, errors
$ay e3ist in valuation $oels, or $isunerstanings $ay e3ist concerning an
asset or a -ro9ect -ro-osal"
103
5.1".5. 4ntangible assets
The valuation o+ intangi#le assets such as #ran na$es an -atents is a
su#9ective area, an esti$ates o+ the value o+ an intangi#le asset $ay vary
!iely"
In so$e cases, a $arket value $ay #e esti$ate +or an intangi#le asset"
In general, ho!ever, the value -lace on an intangi#le asset $ay #e #ase on
the inco$e that the #usiness $ay receive ue to the asset"
2or e3a$-le, a -atent $ay have a @ero value unless it is use +or
$anu+acturing, -roviing services, or is license to other #usinesses in return
+or license +ees"
In contrast, a -atent $ay have a high value in the case o+ large scale
-rouction, such as the esign o+ a ne! rug that $ay #e istri#ute glo#ally"
In cases !here the asset, such as a -atent, is use in the irect -rouction an
sale o+ a -rouct, or !hen license +ees are receive, a net -resent value
calculation $ay #e -er+or$e"
In other cases, such as #ran na$es an ne!s-a-er $astheas, valuation
$ulti-les coul #e use, or an esti$ate o+ the net inco$e that is ue to the
asset $ay #e $ae"
A valuation o+ an intangi#le asset $ay #e re&uire to -re-are a #alance sheet
in cases !here the asset $ay have signi+icant value"
5.1".!. #trutural :aluation
Structural valuation is not a traitional valuation techni&ue"
=o!ever, this a--roach $ay have a nu$#er o+ avantages as a $etho o+
valuing an asset, -articularly a #usiness or a -ro-erty"
5.1".!.1.3ast returns
The traing history o+ a #usiness $ay not #e an accurate guie to the value
an +uture -ros-ects o+ a #usiness +or several reasons"
100
The ne! #usiness o!ners $ay #e a#le to i$-rove the returns +ro$ the
#usiness through i$-rove $anage$ent, or ca-ital invest$ent in ne!
e&ui-$ent or -roucts"
Also, the ne! o-erators $ay !ish to change the #usiness o-erations
su#stantially an create a #usiness o-eration that is &uite i++erent to the
-revious o-eration"
In other cases, the -revious returns $ay not #e sustaina#le, an +uture results
$ay not $atch the -revious traing results"
This $ay occur !hen the #usiness ha e3-erience a -erio o+ unusually
strong traing conitions, an !hen the #usiness ha strong returns #ase on
issues that !ere relate to the -revious o-erators, such as -ersonal contacts o+
the -revious #usiness o-erators"
5.1".!.2.#trutural valuation
An alternative a--roach to traitional $ethos $ay involve a revie! o+ the
structure an co$-onents o+ the #usiness, rather than its traing history"
This $ay inclue yna$ic issues such as the current level o+ cash +lo!s, as
!ell as static issues such as the assets o+ the #usiness"
A structural a--roach $ay avoi $any -ro#le$s !ith valuations #ase on
traing history, an $ay +ocus on the +uture -ossi#ilities +ro$ the e3isting
#usiness enter-rise"
2or e3a$-le, a valuation o+ a restaurant $ay asses the nu$#er o+ ta#les, the
+loor area, the value o+ the assets an the recent traing history"
These +actors $ay #e inclue in a co$-arative valuation !ith other recent
sales"
=o!ever, the structural a--roach $ay +ocus on the o-erations that coul #e
#uilt !ith the availa#le assets, rather than the -revious o-eration"
A structural valuation $ay value the current #usiness structure"
=o!ever, a structural valuation $ay also #e #ase on the -otential #usiness
o-eration that coul #e create +ro$ the resources o+ the #usiness"

10*
The outco$e o+ a structural revie! $ay #e an esti$ate o+ the net inco$e that
coul #e receive +ro$ #uiling a #usiness o-eration +ro$ the availa#le
assets"
A valuation o+ the #usiness $ay then #e eter$ine +ro$ this esti$ate o+ the
-otential inco$e"
2or e3a$-le, a revie! o+ a #usiness enter-rise $ay inclue the +ollo!ing
in+or$ationE
/o$-any ?WX #ill#oars
A-eration 7esigning, -rinting an asse$#ling avertising
#ill#oars"
Assets A++ice e&ui-$ent G10, #ill#oars G80
/usto$ers 20 long<ter$ contracts, -reviously an average o+
30 casual orers -er $onth"
/urrent %$-loyees 1 rece-tionist, 2 gra-hic artists, 1 -rinter, 0
e$-loyees asse$#ling an trans-orting #ill#oars
%sti$ate o+
-otential net inco$e
G1* -er annu$
'aluation G100"
Base on a 1*L yiel, i"e" a $ulti-le o+ )"8 ti$es
earnings"
A structural a--roach to valuing a #uiling $ay consier the +loor s-ace, the
location, an the ty-e o+ #uiling structures e3isting on the -ro-erty"
A valuation $ay then consier the -ossi#le uses +or the #uiling, the ca-ital
invest$ent re&uire an the rental inco$e in each scenario, an $ay +inally
erive a valuation +ro$ these +igures"
7isavantages !ith structural valuation $ay inclue the +act that this
a--roach $ay -rovie a #roa valuation rather than a -recise outco$e"
10)
Also, a level o+ kno!lege o+ the inustry $ay #e re&uire in orer to
esti$ate the -otential inco$e"
A structural valuation $ay inclue the +ollo!ing ste-s"
1" Asses the assets an co$-onents o+ the #usiness"
2" 7eter$ine -ossi#le structures an o-erations"
3" %sti$ate the -otential inco$e +ro$ each alternative"
0" A--ly a $ulti-le to the -otential net inco$e to calculate a valuation"
The $ulti-le that $ay #e chosen $ay e-en on the risk involve in the
#usiness, the gro!th -otential, an the $ulti-les availa#le +ro$ alternative
invest$ents"
5.1".!.3.4ssues 5it.in a strutural valuation
So$e o+ the +ollo!ing issues $ay #e consiere in eter$ining a structural
valuation
A-erating licenses hel #y the #usiness"
Margins !ithin the inustry that the #usiness o-erates in"
5hysical assets such as lan, #uilings an e&ui-$ent"
/urrent arrange$ents !ith custo$ers, su--liers an e$-loyees"
The $a3 o+ -hysical assets, an the #usiness activities that the assets
$ay #e suita#le +or"
The age an conition o+ the -hysical assets"
Recent volu$es o+ trae"
Seasonal issues, an volu$es o+ trae at various ti$es o+ the year"
108
5otential alternative uses +or the assets an alternative #usiness
activities"
7istri#ution arrange$ents that are currently in -lace +or istri#uting
the #usinessCs -roucts"
The si@e an co$-osition o+ esta#lishe custo$er or client #ases"
Trens !ithin the inustry, such as consoliation, e3-ansion, high or
lo! gro!th rates, an consoliate into a s$all nu$#er o+
o-erations or +rag$ente into $any o-erations"
The long<ter$ likely volu$es o+ trae in co$-arison to the recent
traing results"
The level o+ ca-ital e3-eniture that $ay #e involve in revitalising
a #usiness activity"
5.1".!.4.Business proesses
Revie!ing the structure o+ the #usiness $ay involve a revie! o+ all current
#usiness arrange$ents"
This $ay inclue the current arrange$ents !ith custo$ers, su--liers, an
e$-loyees"
The #usiness -rocess $ay involve the current o-erations o+ the #usiness,
incluing arrange$ents !ith custo$ers, su--liers an e$-loyees, an the on<
going +lo! o+ inco$e an e3-enses"
A #usiness -rocess $ay have a value that is se-arate +ro$ the -hysical assets
o+ the #usiness"
This coul #e ter$e the :structural value; o+ the #usiness, an !oul #e
e&ual to the i++erence #et!een the value o+ the assets, an the value o+ the
#usiness as an o-erating enter-rise"
101
5.1".!.5.Ta6eovers an( business pur.ases
Structural valuation $ay also #e relevant in the case o+ -urchasing another
#usiness"
In this case, a structural valuation -rocess $ay #e -er+or$e on the -otential
#usiness that coul #e constructe +ro$ the co$#ination o+ the current
#usiness activity an the target #usiness"
In this situation, the value o+ the -urchase $ay #e eter$ine +ro$ the
-otential value o+ the co$#ine #usiness o-eration, less the value o+ the
current #usiness o-eration"
106
5.1".7. #ummar$ of valuation approa.es
Market trae value %sti$ating a $arket -rice or value +ro$
recent sales o+ the sa$e asset, +or e3a$-le the
last sale o+ a share or a co$$oity"
4et asset value The su$ o+ the value o+ the #usinessCs assets,
less the e#ts" A -re$iu$ or iscount $ay #e
a--lie to the net asset +igure to eter$ine a
#usiness value, #ase on the -ro+ita#ility o+
the #usiness, the sta#ility o+ inco$e, an the
+uture gro!th -otential"
4et -resent value A value #ase on iscounting the e3-ecte
+uture cash +lo!s +ro$ an asset to an
e&uivalent -resent value"
/o$-arative valuation 7eter$ining an esti$ate asset value #ase
on recent sales o+ si$ilar assets"
'aluation $ulti-les . yiels A--lying a $ulti-le or yiel, #ase on recent
sales or alternative invest$ents, to a +igure
such as the net -ro+it, cash +lo!, net assets
an so on, to calculate an esti$ate value +or
the asset"
Structural valuation %sti$ating the -otential net -ro+it o+ the
o-eration, #ase on the current structure or a
-otential structure, an eriving an esti$ate
o+ the asset value #y a--lying a $ulti-le to
the esti$ate -otential net -ro+it"
Rule<o+<thu$# valuation A #asic calculation, such as a value o+ ten
ti$es net -ro+it, use to -lace -otential
transactions in conte3t, an to check +or errors
in other valuation +igures"
1*0
#.11. 6etho(s of asset sales
The sale o+ an asset occurs !hen a -ro-erty, #usiness, -ro9ect or other asset is
sol"
A sale -rocess $ay #e hanle in a variety o+ !ays
5.11.1. Diret Offer
Hner a irect o++er a--roach, the asset $ay #e o++ere +or sale at a s-eci+ic
-rice"
The sale occurs !hen a #uyer chooses to acce-t the o++er an a transaction is
conucte"
This is a si$-le arrange$ent an is o+ten use +or asset sales"
A irect o++er $ay have a #ene+it in that the sale -rice is kno!n in avance"
As either a #uyer or a seller, the #usiness can evelo- -lans an #ugets,
check valuations, an consier +uture -ossi#ilities #e+ore -roceeing !ith the
transaction"
A irect o++er $ay also avoi the -ossi#ility o+ a long -erio o+ negotiation,
!hich $ay result in ti$e elays, an uncertain +inal -rice, an an
un+avoura#le outco$e ue to greater #argaining -o!er #y the other -arty"
A isavantage !ith a irect o++er $ay #e that the o++er $ay nee to re$ain
o-en +or a -erio o+ ti$e #e+ore a #uyer a--ears"
Also, i+ the ite$ is o++ere at a -rice that is a#ove the $arket -rice, a
transaction $ay not occur"

5.11.2. Diret =egotiation
A irect negotiation occurs !hen an iniviual #uyer an seller enter a
-erio o+ iscussion an negotiation to eter$ine a -rice, an to eter$ine
!hether a transaction !ill -rocee"
In this $etho there $ay #e high chance that a transaction !ill -rocee"
1*1
7isavantages !ith irect negotiation $ay inclue the -ossi#ility o+ an
un+avoura#le outco$e i+ the other -arty has greater #argaining -o!er, an an
uncertain +inal -rice"
2or e3a$-le, in a $arket !ith only one $a9or custo$er an several
su--liers, the custo$er $ay have su-erior #argaining -o!er, as the custo$er
can !alk a!ay +ro$ the negotiation an source goos +ro$ another su--lier,
!hile the su--lier $ay have no alternative #ut to su--ly a single custo$er"
The o--osite case $ay occur !hen an essential in-ut is only availa#le +ro$ a
single su--lier"
This $etho $ay #e use #et!een su--liers an custo$ers in transactions
involving large volu$es o+ goos, such as the sale o+ #ulk $ining
co$$oities"
5.11.3. Bi( & Offer
A #i<an<o++er $etho involves a series o+ #is an o++ers"
This $ay involve t!o -arties announcing #is an o++ers regaring a single
asset, or $ulti-le #uyers an $ulti-le sellers $ay loge #is an o++ers +or
assets that are sol in large volu$es"
This syste$ i++ers +ro$ a negotiation -rocess, in that no iscussions are
involve"
A transaction occurs !hen a -arty acce-ts a current #i or o++er"
In the case o+ a single asset, the ite$ $ay #e initially o++ere +or sale at a
s-eci+ie -rice"
The #uyer $ay then acce-t the -rice, or su#$it a #i at a lo!er -rice"
The seller $ay acce-t this #i, $aintain the current o++er, or reuce the o++er
-rice"
This -rocess $ay continue until one -arty acce-ts a current #i or o++er, or
choses to !ithra! +ro$ the negotiation"
The #i an o++er syste$ $ay have several #ene+its"
1*2
This $etho is -articularly suita#le !hen there are a large nu$#er o+ #uyers,
a large nu$#er o+ sellers, or #oth"
7iscussion is not involve in the #i an o++er syste$"
The lack o+ iscussion $ay avoi a consiera#le a$ount o+ ti$e an e++ort
that $ay #e involve in a irect negotiation"
Also, in the case o+ a large volu$e o+ transactions, irect iscussion $ay not
#e -ractical"
The only actions availa#le in a #i an o++er syste$ are the +ollo!ingE
,oge a ne! #i or o++er"
/hange a current #i or o++er"
Dithra! a #i or o++er"
Acce-t a #i or o++er, an a transaction occurs"
7isavantages !ith this syste$ $ay inclue the +act that several changes in
#is or o++ers $ay nee to #e $ae #e+ore a transaction +inally occurs"
This syste$ $ay involve a higher +ailure rate than a irect negotiation, !ith a
larger -ercentage o+ transactions +ailing to -rocee ue to one -arty
!ithra!ing +ro$ the -rocess"
Also, long elays $ay result !hen #oth the #uyer an the seller $aintain
their -ositions an !ait +or the other -arty to alter their #i or o++er"
A #i an o++er syste$ $ay #e use in large scale +or$al $arkets, such as
stock e3changes"
This $etho $ay also #e use in large transactions such as the sale o+ a
#usiness, !here each #i $ay rest +or !eeks or $onths #e+ore an u-ate #i
is su#$itte"
1*3
5.11.4. E)pressions of interest
%3-ressions o+ interest involve -osting a notice that an ite$ is +or sale, an
inviting -otential #uyers to su#$it o++ers or to signi+y that they $ay #e
intereste in negotiating a -urchase o+ the asset"
This $etho $ay #e use +or the sale o+ large assets, -articularly #usinesses"
A notice $ay #e issue in a ne!s-a-er calling +or e3-ressions o+ interest, an
invest$ent #ank or stock#roker $ay contract -ossi#le #uyers to in+or$ the$
o+ the situation, or general in+or$ation $ay #e $ae kno!n !ithin a s$all
inustry"
2ollo!ing the notice, a -erio o+ several !eeks or $onths $ay -ass in !hich
-otential #uyers $ay loge notices o+ interest"
This $ay take the +or$ o+ si$-ly contacting the seller an inicating that the
-arty !oul #e intereste in having iscussions a#out a -ossi#le sale, it coul
involve a -reli$inary !ritten su#$ission, or it $ay involve a re&uest +or
aitional in+or$ation"
In so$e cases, a etaile ocu$ent $ay have #een create a#out the asset,
such as a +ull set o+ accounts an a etaile escri-tion o+ a #usiness +or sale,
or a s-eci+ication o+ the services re&uire +or a contract services agree$ent"
2ollo!ing the initial su#$issions, a short list o+ serious #uyers $ay #e
co$-ile, an then etaile negotiations $ay -rocee !ith several -otential
#uyers until a sale transaction is agree"
This syste$ $ay #e relevant in cases !here an asset coul #e -ut to a range
o+ i++erent uses, an !here the sale -rice $ay #e e-enant on a #uyer
-urchasing the asset +or a s-eci+ic -ur-ose"
A large area o+ vacant lan $ay #e an e3a$-le o+ this situation"
In this situation, a -otential #uyer $ay loge an e3-ression o+ interest in
-urchasing a section o+ the lan, in -urchasing the entire -arcel o+ lan +or
su#ivision !ith elaye -ay$ent ter$s, or $ay -ro-ose a 9oint venture
-ro9ect evelo-$ent"
1*0
5.11.5. Ten(er
A tener syste$ involves -otential #uyers su#$itting !ritten o++ers"
The seller $ay then select a tener #ase on the -rice o++ere, an -ossi#ly
other issues such as the ti$ing o+ -ay$ents, an the trans+er o+ an asset in
stages"

,arge -ro-erties are so$eti$es sol #y tener, an this syste$ is also use
!hen selling assets uring co$-any li&uiations an sales o+ #usinesses"
This syste$ $ay have a #ene+it +or a seller in that the #uyers only have the
o--ortunity to su#$it a single #i"
In this situation, #uyers $ay su#$it strong #is +or the asset, as a lo! #i
-rice $ay result in the asset -urchase #eing lost"
In the case o+ a +i3e o++er or an auction, a #uyer $ay have #een !illing to
-ay a higher -rice, an the seller $ay loose the -otential #ene+it that they
$ay have gaine +ro$ a higher sale -rice"
=o!ever, in cases !here #uying interest $ay #e lo!, teners $ay not #e
su#$itte, or -urchase o++ers that are su#$itte $ay #e lo!"
Buying an asset #y tener $ay re&uire a etaile kno!lege o+ the $arket
value o+ the asset, an $ay also involve a care+ul consieration o+ the likely
#is that the seller $ay receive +ro$ other -arties"
5.11.!. 'ution
An auction $ay #e conucte at a -articular ti$e an -lace"
5otential #uyers $ay asse$#le together, an #uyers $ay issue #is either
ver#ally or using so$e other syste$ such as raising a #ier nu$#er car"
Bis $ay continue, !ith each #i #eing higher than the last, until a +inal #i
stans an no other #is are $ae"
2ollo!ing a short elay, the auctioneer $ay eclare that the auction has
+aile an that the asset !ill not #e sol, ue to the reserve -rice not #eing
reache, or $ay eclare that the asset !ill #e sol to the +inal #ier at the
+inal #i -rice"
1**
Auctions $ay #e use in a !ie range o+ co$$ercial situations"
Assets sol #y auction inclue -ro-erties, art!orks, an general assets uring
li&uiations"
,icenses to o-erate certain activities are so$eti$es sol #y auction,
-articularly !hen there is a li$ite &uantity availa#le"
A license to use certain raio +re&uency s-ectru$s $ay #e an e3a$-le o+
this"
Businesses are not usually sol #y auction"
Auctions are also use in so$e $arkets, !here a range o+ !holesale #uyers
an sellers $ay asse$#le in an auction venue an trae co$$oities #y
auction"
2or e3a$-le, cattle an !ool are sol #y auction"
5ossi#le avantages !ith an auction sale $ay inclue the +act that there $ay
#e a high likelihoo that a transaction !ill #e occur, -articularly !hen the
seller si$-ly !ishes to sell the asset at the highest availa#le -rice, !hatever
that $ay #e"
Also, !hen there are a large nu$#er o+ #iers, this $ay rive the -rice to a
higher level than $ay #e achieve #y a irect o++er"
An auction $ay also have a #ene+it in that an auction $ay occur on a kno!n
ate, an $ay #e co$-lete !ithin a short -erio o+ ti$e"
This is in contrast to other $ethos that $ay take !eeks or $onths +or a sale
to occur"
In the case o+ a li$ite nu$#er o+ active #iers, ho!ever, an auction sale
$ay not -rouce a strong sale -rice"
In this case, the highest #ier $ay only raise their #i until other -arties
!ithra!, !hich $ay #e #elo! the -rice that they !oul have #een !illing
to -ay, an $ay #e #elo! the -rice that coul have #een achieve +ro$ a
+i3e<-rice sale over a -erio o+ ti$e"
Although a negotiation or a +i3e<-rice o++er $ay #e use a+ter an auction, in
-ractice the auction -rocess $ay e3haust #uying interest, an the seller $ay
#e una#le to o#tain a signi+icantly higher -rice than the +inal #i"
1*)
5.11.7. Dut. 'ution
A 7utch auction $ay involve #eginning !ith a high -rice, an graually
reucing the -rice until a #uyer acce-ts the current o++er"
This syste$ is na$e in re+erence to the syste$ that !as use to sell tuli-
#ul#s in =ollan in the istant -ast (>> check ti$eJcurrent usage)"
The 7utch auction syste$ $ay #e use to sell so$e co$$oities"
In these cases, #uyers an sellers $ay asse$#le in an auction venue an
ite$s $ay #e -rocesse in lots, a :lot; #eing a single auction transaction"
A 7utch auction $ay #e use+ul !hen a large volu$e o+ transactions $ust #e
conucte, as each transaction $ay #e +inalise very &uickly"
In so$e arrange$ents, a clock $ay #e set !ith a -rice that escens at a
steay -ace to!ar @ero, !ith the sale #eing $ae at the current clock value
#y the +irst -erson that signals an agree$ent"
This syste$ $ay ena#le a large nu$#er o+ se-arate transactions to #e carrie
out !ithin a reasona#le -erio o+ ti$e"
5.11.8. #trateg$ in sales an( pur.ase
An e++ective asset sale or -urchase $ay involve a nu$#er o+ ste-s"
Be+ore o++ers are loge or negotiations are co$$ence, a valuation -rocess
$ay #e involve"
This $ay involve a -ersonal assess$ent o+ the asset, #ase on recent sales,
valuation $ulti-les, or other a--roaches"
In so$e cases, a +or$al valuation $ay #e arrange +ro$ a valuation +ir$
#e+ore the -urchase or sale -rocess #eings"
An e++ective valuation $ay involve asse$#ling a range o+ in+or$ation, such
as the -rice an etails o+ recent sales, an the conition o+ the asset itsel+"
2ollo!ing a valuation -rocess, a -rice li$it $ay #e eter$ine #e+ore the
selling or -urchase -rocess #egins"
1*8
In the course o+ a negotiation -rocess, it $ay not #e -ossi#le to consier
alternatives an to +or$ an o-inion o+ -rices"
In general, these ste-s $ay nee to #e taken #e+ore a negotiation or auction
co$$ences"
The a--roach o+ the o--osing -arty, or co$-eting #iers in an auction $ay
not #e kno!n in avance, an in general a #usiness shoul #e -re-are to
!ithra! +ro$ #iing or negotiations at an a--ro-riate ti$e"
5.11.9. #ummar$ of sale met.o(s
7irect o++er An asset is o++ere +or sale at a +i3e -rice"
4egotiations are not conucte, an a sale occurs
!hen a #uyer acce-ts the o++ere -rice" The o++er
-rice $ay #e reuce i+ an e3tene -erio o+
ti$e -asses !ithout a sale occurring" This $etho
$ay #e use in retail o-erations, an +or the sale
o+ s$all or large assets"
7irection negotiation A irect negotiation $ay take -lace #et!een t!o
-arties, #ase on iscussions until an agree$ent is
reache" A lo! #i -rice or a high o++er -rice $ay
#e use initially to #egin the negotiation -rocess"
This $etho $ay #e use +or the sale o+ large
assets, an +or co$-le3 arrange$ents such as
-ro9ects or 9oint ventures"
Bi . o++er Bis are su#$itte #y $ulti-le #uyers, an o++ers
are su#$itte #y $ulti-le sellers" In the case o+ a
single asset, a #uyer an seller $ay announce #is
an o++ers in se&uence" Transactions occur !hen
one -arty acce-ts a current #i or o++er o+ another
-arty" This $etho is use #y stock e3changes"
Auction Buyers loge co$-eting #is in a series o+
#iing, until one #i re$ains an no +urther #is
are $ae" This #eco$es the highest #i, an the
seller $ay acce-t the #i, re9ect the #i, or o++er a
negotiation -rocess" This $etho is use to sell
1*1
-ro-erties, an ite$s such as art !orks,
collecti#les, an co$$oities"
Tener Buyers each su#$it a single o++er in !riting, an a
tener is selecte #y the seller" This $etho is
use to sell large assets"
7utch Auction The auction -rice co$$ences at a high level, an
the -rice steaily reuces until a #uyer acce-ts the
current -rice" This $etho $ay #e use in so$e
co$$oity $arkets that involve a large nu$#er o+
transactions"
%3-ressions o+ interest An announce$ent is $ae concerning an asset +or
sale or a -ro-ose transaction, an !ritten or
ver#al e3-ressions o+ interest $ay #e loge as a
-reli$inary ste- in a negotiation or a contract
arrange$ent"
#.1. E8it strategies
%very #usiness o!ner !ill e3it a #usiness o-eration, even i+ this only occurs
through eath"
/onsiering the +uture o-tions +or e3iting a #usiness $ay #e an i$-ortant
issue in eter$ining a #usiness structure"
This $ay a++ect the choice o+ legal structure, such as a -artnershi-, co$-any
or holings irectly in the iniviualCs na$e"
In so$e cases, -articularly in the case o+ a #usiness +or$e #y a grou- o+
-eo-le, consiera#le regret $ay occur at a later ti$e, in ter$s o+ i++erent
arrange$ents not having #een $ae !hen the #usiness !as +irst esta#lishe"
A ecision to e3it a #usiness $ay arise ue to retire$ent, a lack o+ interest in
continuing to o-erate the #usiness, or continue -ro#le$s !ith the o-erations
an activities o+ the #usiness"
A nu$#er o+ a--roaches $ay #e use #y a #usiness o!ner to e3it the
o-eration o+ a #usiness"
1*6
5.12.1. -et.o(s of e)iting a business ativit$
5.12.1.1.Bit.(ra5al & in.eritane
In so$e cases, the #usiness o-erator $ay retire +or active involve$ent in the
#usiness, an other +a$ily $e$#ers $ay take over the $anage$ent o+ the
#usiness"
In these cases, the assets o+ the #usiness $ay -ass to other +a$ily $e$#ers
through inheritance"
5.12.1.2.Disban(ment
Dithra!al +ro$ a #usiness o-eration $ay #e achieve #y ceasing #usiness
o-erations, selling the #usiness assets, an re-aying any outstaning e#ts"
This o-tion $ay #e use is so$e o+ the +ollo!ing circu$stances"
Dhen the #usiness o!ner -ersonally -er+or$e a signi+icant a$ount
o+ the !ork"
Dhen the #usiness o-erates in a eclining inustry, !ith +alling
sales levels an lo! -ro+ita#ility"
Dhen a #uyer cannot #e +oun +or the #usiness"
Dhen the #usiness !as +or$e +or a s-eci+ic -ro9ect or event, an
the #usiness activity has #een co$-lete"
In the case o+ a #usiness that !as o-erating on a sustaina#le #asis, a higher
value +or the #usiness $ay generally #e receive #y selling the #usiness as an
o-erating enter-rise, rather than ceasing o-erations an selling the assets"
5.12.1.3./loat
A -u#lic +loat $ay #e use as an e3it strategy +or $eiu$ si@e an large
#usinesses"
1)0
A +loat involves selling the #usiness to a large nu$#er o+ investors +ro$ the
general -u#lic"
A -ros-ectus is -re-are, containing a +ull set o+ auite accounts, an a
etaile escri-tion o+ the #usiness"
The +loat -rocess is generally $anage #y an invest$ent #ank or stock
#roker"
This $ay involve so$e o+ the +ollo!ing activities"
Avising on the -ricing o+ the +loat"
Assisting in the -re-aration o+ the -ros-ectus"
,ocating -otential investors"
Hner!riting the +loat #y agreeing to -urchase so$e o+ the shares
irectly, i+ not all o+ the availa#le shares are -urchase"
The shares o+ the co$-any are generally liste +or traing on a stock
e3change a+ter the +loat -rocess has #een co$-lete"
In so$e cases, the #usiness o!ner $ay retain a signi+icant -ro-ortion o+ the
shares as a -assive invest$ent, !hile in other cases the entire #usiness $ay
#e sol"
In cases !here the #usiness o!ner -ersonally $anage the #usiness, a chie+
e3ecutive o++icer or a $anage$ent tea$ $ay nee to #e e$-loye #e+ore the
+loat -rocess !as conucte"
A -erio o+ si3 to t!elve $onths $ay #e re&uire in orer to esta#lish a
sta#le o-eration, #e+ore the +loat -rocess !as atte$-te"
A -u#lic +loat $ay #e a -ractical o-tion in cases !here a #usiness !as
su++iciently large, an !as o-erating on a -ro+ita#le an sustaina#le #asis"
Investor interest in +loats $ay vary signi+icantly !ith changes in econo$ic
an stock $arket conitions"
7uring so$e -erios o+ ti$e, a +loat $ay not #e a -ractical alternative, ue to
a general lack o+ investor interest"
1)1
5.12.1.4.Tra(e sale
A trae sale involves a sale o+ the #usiness to another -arty, generally
another #usiness"
This $ay #e a sale to a co$-etitor, +or e3a$-le"
In this case, the co$-etitor $ay gain an increase in si@e an an increase in
e++iciency through econo$ies o+ scale"
Alternatively, a #usiness that o-erates in another inustry $ay -urchase the
#usiness, either as an invest$ent, or as a $etho o+ gaining entry to another
$arket"
5.12.1.5.#ale to ot.er investors
In the case o+ s$aller enter-rises, !ithra!al $ay involve a sale o+ the
#usiness to another iniviual"
In the case o+ a -artnershi-, another iniviual $ay #uy the -artnershi-
interest +ro$ the !ithra!ing -artner, an 9oin the -artnershi-"
The value o+ the -artnershi- interest $ay #e #ase on the assets o+ the
-artnershi-, an the value o+ the ongoing o-eration, such as an esta#lishe
client #ase"
In the case o+ general #usiness o-erations, another investor $ay #e locate to
-urchase the #usiness o!nerCs share o+ the #usiness, or the entire #usiness"
Businesses are o++ere +or sale through #usiness #rokers, ne!s-a-ers, an a
nu$#er o+ -u#lications"
=o!ever, in so$e cases a long -erio o+ ti$e $ay #e involve #e+ore a
#uyer is +oun +or a #usiness"
In other cases, a #uyer $ay not #e +oun, es-ite the #usiness o-erating on a
-ro+ita#le #asis"
In so$e inustries, sales o+ #usinesses $ay o-erate on a :!alk in, !alk out;
#asis"
1)2
This arrange$ent $ay #e use !ith #usinesses such as ca+es, !here the
-re$ises $ay #e lease, an the #usiness $ay have +e! assets"
This arrange$ent $ay involve a #uyer $aking a no$inal -ay$ent to the
selling #usiness o-erator, to cover assets such as stock on han"
The #uyer !oul then take over o-eration o+ the #usiness +ro$ the seller"
5.12.1.!.Bu$ba6
In cases !here the #usiness o!ner o!ns only -art o+ the #usiness, in so$e
cases a !ithra!al $ay #e i$-le$ente through the #usiness #uying the
shares or the -artnershi- interest irectly +ro$ the #usiness o!ner"
This transaction has the e++ect o+ the #usiness o!ner !ithra!ing their share
o+ the #usiness value in the +or$ o+ cash"
The #usiness $ay then #eco$e a s$aller enter-rise"
This o-tion $ay #e -ractical !hen the share o+ the #usiness is relatively
s$all, or !hen the #usiness assets inclue a signi+icant holing o+ cash"
In the case o+ a larger share o+ the #usiness, the sa$e -rocess coul #e
i$-le$ente, !ith the -ay$ents #eing $ae over a -erio o+ ti$e +ro$ the
net inco$e o+ the #usiness"
5.12.2. Barriers to e)it
A nu$#er o+ issues $ay arise that $ay create i++iculty or cost in e3iting a
#usiness o-eration"
Barriers to e3it $ay #e a signi+icant issue in so$e #usiness situations"
In so$e situations, a #usiness o-erator $ay +in that the #usiness activity
$ay generate a loss, or that a lo! level o+ return $ay #e achieve +ro$ the
#usiness o-eration"
In other cases, a #usiness o!ner $ay si$-ly not have an interest in
continuing the #usiness activity, +or one reason or another, an $ay !ish to
!ithra!"
1)3
2or a nu$#er o+ reasons, !ithra!ing +ro$ a #usiness activity $ay not #e
-ossi#le !ithout incurring a $a9or +inancial loss"
The $ay occur +or so$e o+ the +ollo!ing reasons"
5.12.2.1.T$pes of barrier to e)it
5.12.2.1.1. Termination penalties
In so$e cases, contracts $ay e3ist !ith su--liers, custo$ers o+ other -arties,
that $ay involve +i3e ter$ agree$ents, an ter$ination -enalties"
2or e3a$-le, a #usiness $ay have a t!elve $onth su--ly agree$ent !ith a
custo$er"
I+ the #usiness +aile to continue to su--ly -roucts +or the +ull t!elve $onth
-erio, this $ay re-resent a #reach o+ the contract, an the custo$er $ay sue
the #usiness to recover any losses that they $ay have incurre"
As another e3a$-le, a +ranchise agree$ent or service contract $ay inclue
ter$s that s-eci+y -enalties +or ter$inating the agree$ent #e+ore a +i3e
-erio o+ ti$e ha ela-se"
5.12.2.1.2. ' la6 of bu$ers
Although transactions involving shares an -ro-erties $ay occur in high
volu$es, the sa$e situation $ay not necessarily a--ly in the case o+ a sale o+
a #usiness"
5hysical assets $ay #e -urchase in $any circu$stances"
In the case o+ a #usiness -urchase, ho!ever, this $ay either re&uire a #uyer
!ho !ishes to co$$ence a #usiness o-eration, or locating another #usiness
that !ishes to -urchase the #usiness +ro$ the #usiness o!ner"
In so$e situations, a larger nu$#er o+ #usinesses $ay #e o++ere +or sale,
than there $ay #e #uyers +or a #usiness"
A #usiness o!ner $ay have esta#lishe a success+ul #usiness o-eration !ith
consiera#le value"
1)0
=o!ever, es-ite a #usiness o-erating -ro+ita#ly an having signi+icant net
assets, a #uyer $ay si$-ly not a--ear +or the #usiness"
5.12.2.1.3. 8arge apital investments
In so$e cases, !hich $ay -articularly involve -urchasing a #usiness or
entering a -ackage #usiness o--ortunity, a large invest$ent $ay #e $ae to
co$$ence the #usiness o-eration, or to -urchase an asset"
An on<going value +or the invest$ent $ay #e receive #y continuing to
o-erate the #usiness"
=o!ever, i+ a #uyer cannot #e +oun, then the #usiness o!ner $ay loose the
value o+ the initial invest$ent i+ they !ithra! +ro$ o-erating the #usiness"
A si$ilar situation $ay a--ly in cases !here large e3-enses $ay have #een
$ae +or a +uture #ene+it, such as the costs o+ a ne! -rouct evelo-$ent,
the cost o+ esta#lishing a -rouct !ithin a ne! $arket, an so on"
5.12.2.2.'voi(ing barriers to e)it
In so$e cases, a #usiness o!ner $ay continue to o-erate a #usiness +or $any
years against their esire, ue to the costs that $ay #e involve in e3iting the
#usiness"
5otential -ro#le$s !ith #arriers to e3it $ay #e reuce #y +ollo!ing so$e o+
the +ollo!ing a--roaches"
5.12.2.2.1. +ontrats
/ontracts that inclue long $ini$u$ ter$s $ay nee to #e consiere
care+ully #e+ore they are acce-te"
In so$e cases, a #usiness o!ner $ay have intentions o+ continuing the
#usiness activity +or an e3tene -erio o+ ti$e"
=o!ever, a !ie range o+ une3-ecte events $ay occur, an circu$stances
$ay change signi+icantly #e+ore the contract e3-ires"
1)*
%ntering a contract that inclues long +i3e ter$s $ay create a risk +or the
#usiness"
This issue $ay also a++ect the general a#ility o+ the #usiness to aa-t to
change circu$stances, in aition to e3it issues"
This issue $ay #e aresse in a nu$#er o+ !ays" These $ay inclue so$e
o+ the +ollo!ing a--roaches"
/are+ully consiering the ter$s an conitions o+ contracts, #e+ore
acce-ting contact ter$s"
Avoiing long<ter$ +i3e -erio contracts, an using short<ter$ or
+loating agree$ents that $ay not involve s-eci+ic -erios o+ ti$e"
Incluing ter$ination conitions as ter$s !ithin a contract" In so$e
cases, a ter$ination -enalty $ay #e inclue, ho!ever this $ay #e
lo!er than the loss that $ay have occurre on ter$inating a +i3e<
ter$ contract that i not inclue s-eci+ic ter$ination conitions"
5.12.2.2.2. ,ealisti e)it senarios
In #uiling a #usiness, a realistic vie! o+ the e3it value o+ the #usiness $ay
nee to #e $aintaine"
In cases !here a #usiness o!ner $ay o-erate as a sole traer an $ay
-er+or$ all or $uch o+ the !ork -ersonally, a #usiness $ay have no salea#le
value"
In so$e cases, a long -erio o+ ti$e $ay #e re&uire in orer to locate a
#uyer +or a #usiness"
In co$$encing an o-erating a #usiness, a #usiness o!ner $ay nee to
consier the -ossi#ility that a #uyer $ay never #e +oun +or a #usiness"
In this case, the only value that $ay #e salvage +ro$ a #usiness o-eration
$ay #e the value o+ selling the assets o+ the #usiness, i+ any"
1))
5.12.2.2.3. 3ersonal assets
In so$e #usiness situations, the entire #usiness -ro+its $ay nee to #e re<
invest$ent in the #usiness activity to $aintain the #usiness o-eration on a
sustaina#le #asis, or to e3-an the #usiness"
Inco$e +or the #usiness o!ners in these circu$stances $ay take the +or$ o+
-ay$ents +or -ersonal inco$e an e3-enses"
=o!ever, !here -ossi#le, a strea$ o+ iviens $ay #e ra!n +ro$ the
#usiness, an use to accu$ulate -ersonal assets"
Dith a risk arising that a #usiness $ay have little or no value !hen a ti$e
$ay arrive to cease o-erating the #usiness, the #usiness o!ners $ay consier
accu$ulating -ersonal assets, se-arately +ro$ the #usiness, over a -erio o+
ti$e"
Retire$ent $ay #e one situation in !hich this -ro#le$ $ay arise"
#.1!. Buying a business
Buying a #usiness $ay involve several avantages as a $etho o+
co$$encing #usiness o-erations in co$-arison to starting a ne! #usiness"
5.13.1. '(vantages
The risk involve in #uying an e3isting #usiness $ay #e +ar lo!er than the
risk involve in a start<u- enter-rise"
An e3isting #usiness $ay have an esta#lishe client #ase, ongoing
o-erations, an !oul generally have -ositive cash +lo! an #e -ro+ita#le"
%3ce-tions to this $ay inclue -urchasing a istresse #usiness, !hich is a
se-arate situation to co$$encing ongoing #usiness o-erations"
In the case o+ a start<u- enter-rise, an initial -erio o+ ca-ital e3-eniture an
negative cash +lo! $ay #e involve, ho!ever the +uture inco$e +ro$ sales
$ay #e uncertain"
1)8
In contrast, -urchasing an esta#lishe #usiness that !as in soun conition
$ay allo! the #usiness o!ners to co$$ence regular #usiness o-erations
i$$eiately"
This a--roach $ay also avoi a long ti$e elay that $ay #e involve in
evelo-ing a start<u- enter-rise to a sustaina#le level o+ o-eration"
5.13.2. Disa(vantages
A nu$#er o+ isavantages $ay also a--ly to the o-tion o+ -urchasing an
e3isting #usiness"
Goodwill
In the case o+ an esta#lishe #usiness, a su#stantial cost a#ove the value o+
the net assets $ay #e re&uire to -urchase the #usiness"
In general, the value o+ a #usiness increases !ith the level o+ sta#ility o+ the
#usiness inco$e, an the -otential +or +uture gro!th"
A #usiness that involve a sta#le net -ro+it, soli $argins an cash +lo!, an
a -ositive gro!th outlook $ay trae at a high -rice"
The aitional -rice a#ove the net assets is the accounting :goo!ill; value,
an corres-ons to the value o+ the #usiness structure, an the value o+ the
esta#lishe +lo! o+ custo$ers"
This ter$ originally re+erre to the +act that an esta#lishe #ase o+ regular
custo$ers involve a value +or the #usiness that !as higher than the value o+
the net assets"
In so$e cases, the -rice o+ a #usiness $ay trae at a high $ulti-le o+ net
-ro+it"
In these cases the -ro+it return +ro$ -urchasing the #usiness $ay re-resent
little $ore than the return that coul #e earne +ro$ investing the +uns in a
#ank e-osit or other traitional invest$ent"
Alternatively, the goo!ill -rice coul #e vie!e as an e3-ense o+ entering
the #usiness o-eration, an !ritten o++ i$$eiately as a loss"
1)1
In contrast, in the case o+ a start<u- enter-rise, a goo!ill e3-ense oes not
have to #e -ai"
=o!ever, a start<u- enter-rise $ay nee to invest large su$s o+ ca-ital, an
re<invest cash +lo!, in orer to #uil a custo$er or client #ase to a
sustaina#le level"
A goo!ill -rice $ay also #e avoie through -urchasing a #usiness in
!hich there !ere a range o+ -ro#le$s that neee to #e aresse, or !here
the net -ro+it $ay #e less sta#le that the -ro+it o+ #usinesses that trae on
high $ulti-les"
Purchase price
A #usiness is an intangi#le asset, an valuing a #usiness accurately $ay #e
i++icult"
In the case o+ -urchasing a #usiness, a risk e3ists that an e3cessive -rice $ay
#e -ai, resulting in a loss o+ value"
2or e3a$-le, a #usiness $ay a--ear to #e in a soun conition, !ith sta#le
net -ro+it an soli $argins"
A su#stantial goo!ill -rice $ay #e -ai to -urchase the #usiness"
=o!ever, soon a+ter the #usiness o!ners co$$ence o-erations, conitions
$ay eteriorate, an the value o+ the #usiness $ay reuce to #e little $ore
than the value o+ the -hysical assets"
This risk o+ this situation occurring $ay #e reuce through ensuring that the
#usiness o!ners have a soun kno!lege o+ the inustry in !hich the
#usiness o-erates, through o#taining an ine-enent #usiness valuation, an
through care+ully assessing the assets an o-erations o+ the #usiness"
9nowledge & e%perience
Another -ossi#le isavantage !ith -urchasing a #usiness, in contrast to a
start<u- a--roach, $ay involve the -rocess o+ evelo-ing the #usiness"
A start<u- #usiness enter-rise $ay involve $any -ro#le$s, an $any lessons
$ay #e learne #y the #usiness o!ners in the -rocess o+ #uiling a #usiness
+ro$ a start<u- -osition to a sustaina#le o-eration"
1)6
In the case o+ -urchasing a #usiness, this kno!lege an e3-erience $ay not
#e gaine #y the #usiness o!ners"
This $ay lea to i++iculty in o-erating an e++ectively evelo-ing the
#usiness in the +uture"
5.13.3. 8oating a business
Businesses are o++ere +or sale through #usiness #rokers, an are avertise
+or sale through various -u#lications"
Business #rokers carry lists o+ #usinesses +or sale, an $ay arrange
negotiations #et!een the #uyer an the seller o+ a #usiness"
5.13.4. :aluation
In so$e cases, a #usiness has a si$-le structure an o-eration, an the value
o+ the #usiness $ay #e esti$ate +airly reaily"
This $ay -articularly a--ly in the case o+ #uyers !ho are +a$iliar !ith the
inustry that the #usiness o-erates in"
=o!ever, in other cases an ine-enent valuation o+ the #usiness $ay #e
sought"
A valuation is arrange #y contacting a #usiness valuer, !ho -re-ares a
etaile re-ort o+ the #usiness an -rovies an esti$ate o+ the #usiness value"
5.13.5. T.e intangible value of a business
%3tre$e care $ay #e re&uire in assessing the o-erations an nature o+ a
#usiness"
In the case o+ a -ro-erty, a section o+ lan an a -hysical #uiling $ay #e
-urchase"
In this case, the value $ay $ove against the ne! o!ners, ho!ever the asset
can #e -hysically ins-ecte, an the asset itsel+ has an ine-enent an on<
going value"
180
In the case o+ a #usiness, the entire value o+ the #usiness $ay #e #ase on the
+act that the #usiness e3ists an o-erates, rather than the value o+ any
-hysical ite$"
2or e3a$-le, a #usiness $ay -rovie cleaning services to co$$ercial o++ice
#uilings"
The #usiness $ay collect +ees +ro$ clients, -ay salaries to e$-loyees, an
-urchase su--lies"
This #usiness $ay generate a signi+icant -ositive cash +lo!, an a su#stantial
-rice $ay #e -ai to -urchase the #usiness"
=o!ever, the #usiness $ay have +e! -hysical assets"
I+ several $a9or custo$ers cancelle their orers, inco$e coul +all to al$ost
nothing"
In this case, the o-eration o+ the #usiness $ay cease, an the #usiness o!ners
$ay loose the entire a$ount that they investe in -urchasing the #usiness"
Hnlike a -hysical asset such as a -ro-erty, the value o+ a #usiness is
e-enant on continuing o-erations"
A #usiness that has a high value at one ti$e $ay have little value i+ o-erating
conitions eteriorate"
5.13.!. 'ssessing a business
A range o+ issues $ay result in the sustaina#le value o+ a #usiness #eing
lo!er than the value that a--eare to e3ist at the ti$e o+ the #usiness
-urchase"
5.13.!.1.3roblems 5it. assessing a business
Accounts and trading results
As !ith any asset, the seller o+ a #usiness $ay #e e3-ecte to -resent the
#usiness in its $ost +avoura#le light, in orer to o#tain a strong sale -rice +or
the #usiness"
181
Activities involve in this -rocess $ay range +ro$ +i3ing -ro#le$s that
shoul have #een +i3e a long ti$e ago, to -roucing an entire set o+
+rauulent accounts an recors, co$-lete !ith non<e3istent assets an non<
e3istent custo$er arrange$ents"
There are $any !ays in !hich a set o+ accounts can #e :resse u-; in orer
to -resent an i$-rove -icture o+ a #usiness +or sale"
This $ay involve issues such as reucing e-reciation rates, -lacing
o-ti$istic valuations on assets, ca-italising e3-enses, an so +orth"
These alterations $ay not involve +alse state$ents, ho!ever the re-orte net
-ro+it +igures $ay #e higher in these cases than the +igures that $ay #e
-rouce #y a $ore conservative accounting treat$ent o+ the #usiness
o-erations"
As another e3a$-le, $aintenance e3-enses coul #e reuce or cancelle, in
orer to $ake the costs o+ the #usiness a--ear to #e lo!"
=o!ever, this $ay not #e sustaina#le on a long ter$ #asis, an the ne!
#usiness o!ners $ay nee to restore the $aintenance activities to -revent
e&ui-$ent +ro$ #eco$ing non<o-erational"
Seasonal and c*clical "usinesses
So$e #usiness activities $ay have sta#le sales an net -ro+it +igures over a
long -erio o+ ti$e"
=o!ever, in the case o+ $ost #usiness activities, there $ay #e su#stantial
i++erences in sales an -ro+it levels +ro$ one -erio to the ne3t, e-ening
on econo$ic conitions, activity !ithin an inustry an so +orth"
A #usiness o!ner $ay #e $ore likely to sell a #usiness uring ti$es o+
strong sales an -ro+it, !hen a high -rice $ay #e achieve, than uring ti$es
o+ slo! activity !hen -rices $ay #e lo! an their $ay #e little interest +ro$
-otential #uyers"
In these situations, the current sales an -ro+it levels o+ a #usiness $ay not
re-resent the average long<ter$ results o+ the #usiness o-eration"
182
Statements "* the previous owners
In so$e cases, +alse or $isleaing state$ents $ay #e $ae #y the -revious
#usiness o!ners, in an atte$-t to secure a higher selling -rice"
In other situations, state$ents $ay #e $ae in goo +aith"
=o!ever, these state$ents $ay si$-ly re-resent the vie!s an -ers-ective
o+ the -revious #usiness o!ner, an these state$ents $ay #e $ore
$isleaing in so$e causes that state$ents that are eli#erately +alse"
In either case, iscussions !ith other -arties $ay clou the a#ility o+ the
#uyer to think clearly an o#9ectively, an to +or$ a clear vie! o+ the value
o+ the #usiness, an the -otential #usiness o-erations"
5.13.!.2.'ssessing a business
The assets o+ a #usiness shoul generally #e -ersonally ins-ecte #y the
#usiness #uyer"
This $ay allo! the #usiness #uyer to veri+y the nature o+ the assets, an
#eco$e +a$iliar !ith the assets involve in the #usiness -urchase"
5revious traing results $ay also #e revie!e"
As a $ini$u$, the -revious t!elve $onths o+ $onthly +igures $ay #e
neee in orer to +or$ an assess$ent o+ the o-erations o+ a #usiness"
Although the -revious traing results o+ a #usiness $ay #e an i$-ortant in-ut
to the assess$ent -rocess, in general a #usiness assess$ent shoul #e #ase
on the assets an structure o+ the #usiness, rather than the #usinessCs -revious
results"
This a--roach $ay avoi -lacing an inaccurate value on a #usiness #ase on
-revious traing results"
5revious traing results $ay #e higher than sustaina#le +uture levels, ue to a
-ast -erio o+ strong activity, -ersonal contacts or issues relating to the
-revious #usiness o!ners, or the $ethos use in -re-aring an -resenting
the traing results"
In other cases, the -revious results $ay unerstate the -otential o+ the
#usiness"
183
This $ay occur !hen the #usiness o!ners $ay have lost interest in o-erating
the #usiness over a -erio o+ ti$e, an the #usiness o-erations $ay have
graually eteriorate"
=o!ever, the assets o+ the #usiness $ay #e in soun conition, an the
#usiness $ay have a -otential +or stronger sales an activity levels i+ the
#usiness o-eration !as revitalise"
'aluations $ay #e +re&uently #ase on $ulti-les, such as a $ulti-le o+ ten
ti$es net -ro+it"
=o!ever, the relevant +igure to use in this case is the -otential sustaina#le
-ro+it, not the -revious -ro+it level"
The -otential sustaina#le -ro+it $ay #e higher or lo!er than -revious levels"
This +igure $ay #e esti$ate #ase on the assets an structure o+ the
#usiness"
As an e3a$-le, an e&ui-$ent istri#ution #usiness $ay #e assesse on the
volu$e o+ transactions, the area that is service #y the #usiness, an so on"
These etails $ay then #e use to eter$ine an a--ro3i$ate -otential inco$e
+ro$ the o-eration"
5revious results coul then #e use to check than an e3cessively high or lo!
esti$ate ha not #een $ae"
Research an gaining kno!lege o+ the inustry $ay #e neee in orer to
-er+or$ an assess$ent o+ this ty-e"
=o!ever, this -rocess $ay #e necessary in any event, in orer to e++ectively
o-erate the #usiness activity"
In $any cases, the current o-erational levels $ay #e a $a9or in-ut to the
valuation -rocess"
=o!ever, in -rinci-le the -otential inco$e, rather than the current inco$e,
$ay #e the relevant +igure in assessing a #usiness value"
180
5.13.7. /un(ing
2uning to -urchase an e3isting #usiness $ay #e raise +ro$ a nu$#er o+
sources"
In so$e cases, the #usiness o!ners $ay #e a#le to +un the -urchase o+ the
#usiness +ro$ -ersonal assets"
Bank loans $ay #e availa#le to +un a #usiness -urchase"
=o!ever, this $ay re&uire security, such as a $ortgage over a -ro-erty, an
$ay only #e availa#le in cases !here the #usiness inco$e !as reasona#ly
sta#le"
In so$e #usiness sales, :venor +inancing; $ay #e availa#le"
This $ay involve the seller o+ the #usiness -roviing the +inancing
arrange$ents"
In e++ect, this $ay result in the -rice o+ the #usiness #eing -ai in instal$ents
over a -erio o+ ti$e, !ith the -ay$ents #eing $ae +ro$ the cash +lo! o+
the #usiness"
In so$e situations, e&uity +uns $ay #e source +ro$ investors, an use in
the -urchase o+ the #usiness"
This $ay lea to a long<ter$ -assive invest$ent, or the #usiness -lan $ay
inclue a -lan +or the #usiness o-erators to #uy out the -assive investorCs
share o+ the #usiness over the long ter$, using their share o+ the #usiness
-ro+its"
#.1". 5ranchising
2ranchising is a #usiness $oel that has gaine consiera#le -o-ularity an
success"
5erha-s the #est<kno!n e3a$-le o+ a +ranchise organisation $ay #e the
Mc7onals cor-oration (>>check)"
18*
5.14.1. T.e fran.ising s$stem
The +ranchising syste$ o-erates !ith an organisation that evelo-s -roucts
an conucts $arketing an -ro$otion activities"
The actual -rouction or elivery o+ services is one #y ine-enent #usiness
o-erators, !ho -ay a +ee to the +ranchise organisation in return +or the use o+
the #ran na$e an the -rouct or service esign"
%3a$-les o+ +ranchise organisations $ay inclue retail an +oo outlets, an
services such as ho$e $aintenance"
The #usiness o!ner -ays a license +ee to the +ranchise organisation, !hich
$ay #e regular +i3e ollar a$ount, a -ercentage +ee #ase on sales, or a
co$#ination o+ #oth"
=o!ever, the #usiness o!ner o-erates an ine-enent o-eration"
The inco$e an e3-enses o+ the #usiness +lo! irectly to the #usiness
o-erator, !ith the license +ee #eing an e3-ense o+ the #usiness o-eration"
5.14.2. '(vantages
The +ranchise syste$ $ay #e a lo!er<risk alternative to co$$encing
#usiness o-erations that a start<u- o-eration"
The #ran na$e o+ the organisation $ay #e !ell kno!n, an the #usiness
o!ner $ay receive a steay +lo! o+ custo$ers soon a+ter they co$$ence
o-erations"
Avertising an -ro$otion $ay #e hanle #y the +ranchising organisation,
an in so$e cases a set o+ -roucts $ay also #e availa#le"
The avertising an -rouct evelo-$ent e3-enses $ay #e s-rea across all
the #usiness o-erations, rather than #eing #orne #y the single #usiness o!ner
the$selves"
This -rocess $ay allo! a $ore e++ective avertising an -ro$otion syste$ to
#e conucte than !oul #e -ossi#le in the case o+ a co$-letely ine-enent
#usiness"
18)
The #ran na$e $ay also gain recognition +ro$ the activities o+ the other
ine-enent o-erators, in aition to the #usiness o-erations o+ the #usiness
o!ner the$selves"
5.14.3. Disa(vantages
There $ay #e several isavantages !ith a +ranchise #usiness in co$-arison
to a co$-letely ine-enent #usiness o-eration"
+ee levels
The +ees an charges $ay vary !iely #et!een i++erent organisations"
In so$e cases, the +ees $ay #e lo! an a range o+ &uality -roucts an
success+ul avertising $ay #e -rovie"
In other cases, the +ees $ay #e high an the #usiness o!ner $ay receive little
in return +or the +ee, a-art +ro$ the use o+ the #usiness na$e"
$estrictions on operation
A $ore severe -ro#le$ $ay relate to the restrictions that $ay #e -lace on
the #usiness o!ner"
In $any cases, the #usiness o!ner $ay #e allocate a certain region o+
o-eration"
Hner the ter$s o+ the +ranchise agree$ent, the o-erator $ay not #e
-er$itte to o-erate outsie that region"
This $ay e++ectively -revent the #usiness +ro$ e3-aning in the +uture"
A sole enter-rise $ay #e the esire outco$e"
=o!ever, this -otential li$itation $ay nee to #e recognise in avance, as
this restriction $ay -revent an e3-ansion +ro$ occurring at a +uture ti$e"
In so$e cases, such as the e3a$-le o+ retail stores, this issue $ay not #e
-articularly relevant"
188
A range o+ other restrictions $ay also a--ly in so$e cases, such as a
re&uire$ent to -urchase general su--lies +ro$ the +ranchise co$-any"
Products
In the case o+ -roucts, in so$e cases a set o+ -roucts $ust #e -urchase
irectly +ro$ the +ranchise organisation"
In the case o+ -roucts that are s-eci+ically evelo-e +or the #usiness
activity, this $ay #e a #ene+it o+ the +ranchise arrange$ent"
=o!ever, in the case o+ general su--lies, this $ay li$it the a#ility o+ the
#usiness to select -roucts +ro$ alternative su--liers"
5.14.4. +ommening business as a fran.ise operator
/o$$encing a #usiness as a +ranchise o-erator $ay involve a--roaching a
+ranchise organisation, an e3-ressing interest in #eco$ing a +ranchise
o-erator"
An initial su$ o+ ca-ital $ay nee to #e investe, e-ening on the -articular
situation an the organisation"
A +ranchise agree$ent $ay nor$ally #e involve, !hich !oul #e a contract
#et!een the +ranchise o-erator an the +ranchise organisation"
This contract $ay contain a large nu$#er o+ ter$s, an in general the
+ranchise agree$ent shoul #e revie!e very care+ully #e+ore a ecision is
$ae to sign the agree$ent an co$$ence o-erations"
In so$e situations, an o-erating region $ay #e allocate to the +ranchise
o-erator, !hile in other situations, the o-erator $ay conuct general #usiness
activities !ithout #eing restricte to a certain o-erating area"
5.14.5. +reating a fran.ise business
Another #usiness alternative $ay involve creating a +ranchise organisation"
2ranchise organisations $ay #egin as a s$all success+ul #usiness o-eration"
181
Rather than e3-an in the traitional !ay, a #usinesses $ay chose an
alterative route o+ #eco$ing a +ranchise organisation"
%++ectively, the organisation $ay #eco$e a licensor o+ intellectual -ro-erty,
in a si$ilar !ay to -roucers or $usic or co$-uter so+t!are"
Inco$e $ay #e receive +ro$ the +ees -ai #y the ine-enent o-erators"
The #usiness $ay nee to o-erate success+ully in orer to attract #usiness
o!ners as licensees"
Si$-ly o++ering the use o+ a #usiness na$e an other services $ay not attract
#usiness o-erators unless that #ran na$e alreay ha a signi+icant -ro+ile
Also, this #usiness $oel $ay not #e suita#le +or $any inustries"
A +ranchising $oel $ay a--ly in cases !here a #usiness o-eration service
a li$ite region, such as retail sho-s, +oo outlets, an ho$e services, rather
than inustries in !hich the -roucts !ere istri#ute through a !ie area"
#.1#. 6ergers/ ac4uisitions & (ivestments
An ac&uisition involves the -urchase o+ another #usiness"
A $erger involves t!o se-arate #usinesses $erging to #eco$e a single
#usiness enter-rise"
In the case o+ a ivest$ent, a #usiness unit or a large section o+ the #usiness
$ay #e sol as an ine-enent #usiness"
These activities $ay #e one +or a !ie range o+ reasons !ithin the
evelo-$ent o+ a #usiness activity"
5.15.1. '9uisitions
5.15.1.1.'ess to te.nolog$ & assets
A #usiness $ay #e -urchase to gain access to technology or assets that are
hel #y the target #usiness"
186
2or e3a$-le, the target #usiness $ay have access to a uni&ue -rouction
technology, that $ay ena#le the #usiness to o-erate a $ore e++icient
-rouction -rocess"
So$e o+ the assets that $ay #e ac&uire in this !ay $ay inclue so$e o+ the
+ollo!ing ite$s"
Technology +or $anu+acturing -rouction"
5atents o+ various techni&ues"
Technology inclue !ithin -roucts sol to custo$ers"
A large custo$er #ase"
A license to o-erate !ithin an inustry"
5.15.1.2.'ess to -ar6ets an( in(ustries
A #usiness $ay also #e -urchase as a $etho o+ gaining entry to a ne!
$arket"
In $any inustries, e3-aning a #usiness graually $ay take an e3tene
-erio o+ ti$e, or $ay si$-ly not #e -ractical"
This $ay occur !ithin inustries that are +rag$ente into a large nu$#er o+
organisations, +or e3a$-le"
Also, co$$encing a s$all o-eration an graually e3-aning $ay not #e
-ractical !ithin inustries in !hich econo$ies o+ scale $ay have a
signi+icant i$-act on costs, an !here the inustry is consoliate into a
s$all nu$#er o+ large organisations"
In cases such as these, -urchasing an e3isting #usiness o-eration $ay #e the
only -ractical $etho o+ esta#lishing a sustaina#le -resence !ithin an
inustry"
This situation $ay also a--ly to inustries in !hich a li$ite nu$#er o+
licenses are availa#le, or !hich have consoliate into a s$all nu$#er o+
large organisations"
110
As an e3a$-le, entering the television #roacasting inustry $ay only #e
-ractical through -urchasing an e3isting #roacaster"
As another e3a$-le, a #usiness that o-erate in an esta#lishe, lo!<gro!th
inustry $ay -urchase a #usiness !ithin a high<gro!th inustry as a $etho
o+ gaining a -resence !ithin a gro!th inustry"
5.15.1.3.Eonomies of sale
5urchasing a #usiness $ay #e use to achieve econo$ies o+ scale"
5urchasing another #usiness $ay allo! the #usiness to $ake a large lea- in
sales volu$es"
In turn, this $ay allo! +or the esta#lish$ent o+ high ca-acity -rouction
+acilities, !hich $ay reuce the average cost<-er<unit across the +ull range o+
the #usiness -rouction"
In the case o+ service #usinesses, an ac&uisition $ay increase the nu$#er o+
clients an transactions, an the +i3e costs o+ the #usiness $ay #e a#le to #e
s-rea across a larger nu$#er o+ transactions"
5.15.1.4.4nvestment
A #usiness $ay accu$ulate su#stantial cash holings +ollo!ing an e3tene
-erio o+ success+ul o-eration"
In this situation, a ca-ital istri#ution to shareholers $ay #e conucte"
Alternatively, the +uns $ay #e investe in e3-ansion, ne! -ro9ects, or ne!
+acilities"
Ane alternative in this situation $ay #e to -urchase another #usiness as an
invest$ent"
2or e3a$-le, a #usiness $ay have esta#lishe a success+ul -rouct, !ith a
sta#le an sustaina#le level o+ sales"
In cases !here a #usiness o+ this ty-e !as availa#le +or -urchase at an
attractive -rice, the #usiness $ay -urchase the target #usiness as an
invest$ent"
111
In these circu$stances, the target #usiness $ay #e $aintaine as an
ine-enent #usiness o-eration, !ith the net -ro+it o+ the target #usiness
re-resenting the return on the invest$ent o+ the -urchase -rice"
5.15.2. -ergers
Mergers occur !hen t!o organisations agree to $erge an +or$ a larger
organisation"
A $erger situation $ay occur !hen each #usiness is o+ a si$ilar si@e"
Mergers $ay occur in a nu$#er o+ circu$stances"
5.15.2.1.+onsoli(ating in(ustries
Ane -attern o+ inustry evelo-$ent $ay involve a large nu$#er o+ s$all
#usinesses #eing esta#lishe, +ollo!e #y a graual consoliation into a
s$all nu$#er o+ large #usiness o-erations"
This $ay occur in the case o+ ne! inustries, an also in cases !here ne!
technology or -rocesses allo! econo$ies o+ scale to #e achieve in the
#usiness activities"
In this situation, an iniviual #usiness $ay #e +ace !ith a nu$#er o+
alternatives"
A #usiness coul acce-t an o++er o+ -urchase +ro$ another #usiness"
Alternatively, the #usiness coul re$ain ine-enent an continue
o-erations"
=o!ever, costs an -rices $ay +all steaily in a consoliating inustry, as
-roucers #eco$e larger, an costs<-er<unit ecline ue to econo$ies o+
scale"
In this situation, a #usiness $ay #e una#le to reuce costs an -rices in line
!ith inustry levels, an $ay graually loose custo$ers"
This $ay lea to the eventual closure o+ the #usiness"
112
Another alternative $ay involve $erging !ith an organisation o+ a si$ilar
si@e, in orer to esta#lish a larger organisation an re$ain co$-etitive !ithin
the inustry"
5.15.2.2.'ess to failities
A #usiness $ay also $erge !ith another #usiness in orer to gain access to
+acilities, istri#ution channels, or a source o+ -roucts"
In cases !here ite$s such as these cannot #e o#taine +ro$ su--liers or
through stanar #usiness arrange$ents, a $erger $ay ena#le the #usiness to
continue o-eration as a ne! structure"
5.15.3. Divestments
7ivest$ents occur !hen an ine-enent #usiness unit, or a large -art o+ the
#usiness, is sol as an o-erational #usiness"
This $ay occur in a nu$#er o+ circu$stances"
5.15.3.1.-ultiple business units
In so$e cases, a #usiness $ay o-erate activities in several i++erent
inustries"
2or e3a$-le, a iversi+ie #usiness $oel $ay #e #ase on a #usiness
o-erating a nu$#er o+ se-arate #usiness units in i++erent inustries, as a
$etho o+ reucing risk"
This #usiness $oel #eca$e -o-ular uring the 1610Cs"
=o!ever, although this a--roach $ay reuce risks, in -ractice it $ay also
reuce returns"
This $ay occur as the e++orts o+ the #usiness o-erators cannot #e +ocuse on
several i++erent o-erations at the sa$e ti$e, an i++erent kno!lege an
skills $ay #e necessary +or each inustry"
113
In -ractice, success+ul #usinesses $ay o+ten o-erate !ithin a single inustry
or -er+or$ a single activity, an $ay evote their entire resources to
e++ectively -er+or$ing a single #usiness -rocess"
A #usiness $ay o-erate #usiness units in several inustries ue to -revious
e3-ansion, a -revious ac&uisition o+ a iversi+ie #usiness, or a -revious
-urchase o+ an invest$ent #usiness"
In these situations, a #usiness o-eration in one inustry $ay #e sol to ena#le
the #usiness to +ocus on -er+or$ing a single ty-e o+ #usiness activity"
5.15.3.2.8oss*ma6ing operations
In so$e situations, a section o+ a #usiness $ay o-erate at a continual loss"
7es-ite atte$-ts at restructuring, ne! invest$ent, an changes in -rocesses
or -roucts, losses $ay continue"
In these circu$stances, the #usiness o-eration $ay #e close an the assets
$ay #e sol"
Alternatively, i+ a #uyer can #e +oun, then the #usiness unit $ay #e sol as
an o-erational enter-rise"
This $ay occur, +or e3a$-le, in cases !here a #uyer $ay !ish to e3-an
o-erations #y gaining access to a custo$er #ase, es-ite the +act that the
e3isting o-erations $ay not #e e++ective"
5.15.3.3.Bu$er interest
In so$e situations, #uyers $ay e3-ress interest in -urchasing a #usiness unit,
an $ay #e !illing to -ay a higher -rice that the value o+ the #usiness unit to
the e3isting #usiness"
2or e3a$-le, a #uyer $ay !ish to achieve econo$ies o+ scale, or enter a ne!
inustry, an $ay #e !illing to -ay a -re$iu$ in orer to conuct a
transaction"
In situations such as these, the #usiness unit $ay #e sol, !here the -rice
o++ere $ay e3cee the value o+ the o-eration to the e3isting #usiness"
110
5.15.4. #trutures post an a9uisition
2ollo!ing an ac&uisition o+ a #usiness, a nu$#er o+ i++erent a--roaches $ay
#e taken"
This $ay inclue so$e other the +ollo!ing alternatives"
5.15.4.1.4ntegration
The target #usiness $ay #e integrate !ith the e3isting #usiness o-eration"
This $ay occur !hen the -ur-ose o+ the ac&uisition !as to achieve
econo$ies o+ scale, #y e3-aning the volu$e o+ sales o+ an e3isting set o+
-roucts"
Also, the intention $ay #e to create a single #usiness o-eration that inclue
the +unctions, -roucts or services o+ #oth the -urchasing #usiness an the
target #usiness"
An integration $ay allo! cost savings through eli$inating u-licate
o-erations an reucing sta++ nu$#ers"
2or e3a$-le, the -rouct lines o+ the #uying #usiness an the target #usiness
$ay #e si$ilar, an it $ay #e -ossi#le to reuce the cost an co$-le3ity o+
the co$#ine o-eration #y esta#lishing a single set o+ -roucts"
=o!ever, this -rocess $ay not auto$atically occur si$-ly +ro$ co$#ining
t!o #usiness o-erations"
Reuce costs $ay a--ly in the case o+ ca-ital +acilities that can -rocess
varia#le volu$es, such as $anu+acturing +acilities an co$-uter syste$s"
%3a$-les $ay inclue using a single co$-uter syste$ in -lace o+ several
i++erent syste$s, an consoliating several internal areas that -er+or$
si$ilar activities into a single area"
In so$e cases the co$#ine o-eration $ay #eco$e e3tre$ely co$-le3, !ith
a large nu$#er o+ overla--ing +unctions an u-licate activities"
An integration -rocess $ay involve creating a ne! #usiness structure #ase
on the unerlying +unctions an -roucts o+ the #usiness"
11*
In the case o+ large organisations, this -rocess $ay involve a signi+icant
-erio o+ ti$e an $ay result in the creation o+ a #usiness o-eration that is
signi+icantly i++erent +ro$ the original o-erations o+ either the #uying
#usiness or the target #usiness"
5.15.4.2.#eparate businesses
In so$e cases, the target #usiness $ay #e $aintaine as an ine-enent
o-eration"
This $ay occur !hen the #usiness #eing -urchase o-erates in a i++erent
inustry to the -urchasing #usiness, or !here the target #usiness is -urchase
as an invest$ent"
5.15.4.3.'sset stripping
An asset stri--ing e3ercise involves -urchasing a #usiness, ceasing
o-erations, an selling the assets, or integrating the assets !ith the e3isting
#usiness"
This $ay occur in cases !here the target #usiness $ay have signi+icant
assets, ho!ever the o-erations o+ the #usiness $ay not #e e++ective in
-roucing a sustaina#le #usiness o-eration"
This $ay occur !hen a co$#ination o+ assets has #een asse$#le that is not
suita#le +or a -articular #usiness activity, !hen the #usiness has #een -oorly
$anage, or !hen the #usiness o-erates in a eclining inustry"
5.15.5. +ontrol follo5ing a merger or a9uisition
An ac&uisition $ay have signi+icant i$-lications +or control !ithin the target
co$-any, !hile a $erger $ay involve issues o+ control !ithin #oth
#usinesses"
In the case o+ a $erger, an intense struggle +or control o+ the co$#ine
#usiness $ay occur #et!een senior e3ecutives o+ each o+ the $erging
#usinesses"
11)
In -ractice, the e3ecutives o+ one co$-any or the other $ay eventually !in
out, !ith e3ecutives +ro$ the other original co$-any leaving the #usiness
over a -erio o+ ti$e in a variety o+ !ays"
In the case o+ an ac&uisition that is retaine as a se-arate o-eration, the
ac&uisition -rocess $ay have varying e++ects on the control o+ the target
co$-any"
In so$e cases, the #uying #usiness $ay take irect control o+ the #usiness
o-eration"
In other situations, the #usiness o-eration $ay continue !ith little change"
An ine-enent #oar o+ irectors $ay continue to o-erate, an the only
-ractical e++ect $ay #e that re-orting $ay #e elivere to another #usiness,
rather than #eing issue to shareholers"
In the case o+ integration, control o+ the target co$-any o-eration $ay -ass
into the hans o+ the #uying #usiness"
5.15.!. T.e a9uisition proess
5.15.!.1.Ta6eovers
In the case o+ a liste co$-any, an ac&uisition $ay co$$ence !ith the
#uying co$-any elivering a takeover o++er to the #oar o+ irectors o+ the
target co$-any"
The takeover -rocess is regulate #y s-eci+ic regulations in the co$$ercial
la!"
These regulations $ay s-eci+y the ocu$ents that $ust #e elivere, ti$e
+ra$es +or various ste-s in the -rocess, an actions uner a variety o+
circu$stances"
The o++er -rice !oul usually #e higher than the recent $arket -rice o+ the
shares, as an incentive +or the shareholers to agree to sell their shares"
This $ay lea to a -u#lic announce$ent that a takeover o++er ha #een
receive"
118
This action $ay lea to higher #is #eing su#$itte #y other -otential
#uyers, an over a -erio o+ several $onths a nu$#er o+ o++ers $ay #e $ae
+or the co$-any"
A takeover o++er -rocees !hen a $a9ority o+ shareholers agree to sell their
shares to the #uying #usiness" (>> check -ercentages . scenarios)
5.15.!.2.Diret pur.ase
A irect -urchase $ay occur !hen a -rivate #usiness is -urchase irectly
+ro$ the #usiness o!ners"
This $ay occur !hen the #usiness o!ner ecies to e3it the #usiness +or
retire$ent or other reasons"
In the case o+ large #usinesses, an invest$ent #ank $ay #e use to $anage a
sale -rocess, to esti$ate a value +or the #usiness, an to locate -otential
#uyers"
In the case o+ s$aller enter-rises, a #usiness $ay #e o++ere +or sale through
a #usiness #roker, or avertise +or sale in ne!s-a-ers or other -u#lications"
5.15.7. T.e (ivestment proess
5.15.7.1./loats
In the case o+ a ivest$ent, the #usiness unit $ay #e liste se-arately +ro$
the $ain co$-any on a stock e3change"
This $ay involve the e3isting shareholers receiving a -ro<rata allocation o+
shares in the ne! co$-any"
There is no i$$eiate change in value or short<ter$ e++ect +ro$ this -rocess"
=o!ever, s-litting the co$-any $ay allo! the $anage$ent tea$ !ithin
each #usiness to +ocus on the o-erations !ithin a single inustry"
Aver ti$e, the t!o share -rices $ay iverge, an each co$-any $ay #eco$e
a co$-letely se-arate o-eration"
111
5.15.7.2.Tra(e sales
A trae sale $ay occur !hen a #usiness unit is sol as a co$-lete unit to
another #usiness"
This -rocess $ay allo! cash to #e raise +ro$ the #usiness sale, !hich coul
#e use +or a ca-ital istri#ution to shareholers, +or invest$ent in ne!
-ro9ects or +acilities, or to strengthen the #alance sheet o+ the #usiness"
In contrast, a s-lit o+ the co$-anyCs shares oes not involve raising cash
+ro$ the ivest$ent -rocess"
5.15.7.3.Diret sales
In the case o+ s$aller enter-rises, a section o+ the #usiness !oul not
nor$ally #e sol"
=o!ever, !hen this i occur, the -rocess coul #e $anage through a
#usiness #roker, or -otential #uyers coul #e locate through avertise$ents"
#.1&. 2nternational tra(e & operations
5.1!.1. E)pansion
A #usiness that is o-erating success+ully $ay have several o-tions +or
e3-ansion"
A #usiness $ay increase sales volu$es an custo$er nu$#ers !ithin its
current o-eration, through $arketing, -rouct evelo-$ent, cost e++iciencies
an so on"
Alternatively, the #usiness coul create ne! ty-es o+ -roucts an services,
an enter a ne! $arket that it ha not o-erate in -reviously"
Another o-tion $ay involve retaining the current -roucts an services, an
e3-aning sales into a !ier geogra-hic area"
This $ay involve e3-aning interstate, an e3-aning into +oreign countries"
116
%3-orting is not restricte to large organisations"
Many s$all enter-rises, an even sole traers, $ay e3-ort goos to +oreign
countries, an $ay i$-ort su--lies an e&ui-$ent +ro$ overseas"
International e3-ansion $ay involve e3-orting -roucts to overseas
countries, an $ay also involve esta#lishing o-erations !ithin other
countries"
5.1!.2. T$pes of business
So$e ty-es o+ #usiness $ay #e $ore suite to international e3-ansion than
others"
Businesses that eal irectly !ith the -u#lic, such as retail outlets an irect
service #usinesses, $ay not consier this o-tion ue to the large ca-ital
re&uire$ents that $ay #e involve in esta#lishing a -resence !ithin a $arket
that is #ase on sales to the general -u#lic"

Although large organisations $ay -ursue this -ath, this o-tion $ay generally
#e availa#le to #usinesses !ith large ca-ital resources"
In cases !here the #usiness o-erators $ay #e -ersonally involve in
-roviing the service, such as -ro+essional -artnershi-s, international
e3-ansion $ay not #e co$$only use as an e3-ansion o-tion"

%3-orting $ay #e a !orth!hile o-tion +or co$$oity -roucers"
/o$$oities are ite$s that trae in large volu$es in o-en $arkets, !ith
$any su--liers -roucing si$ilar goos, an $any custo$ers"
This $ay inclue agricultural -roucts, $ining -roucts, an volu$e
-roucts such as stanar co$-uter e&ui-$ent"
5rices $ay +all to the $ini$u$ sustaina#le level in these situations"
Margins $ay #e thin, an -roucers $ay rely on large volu$es in orer to
re$ain -ro+ita#le"
In these cases, e3-orting large volu$es o+ -roucts $ay #e necessary in
orer to create su++icient volu$e to o-erate a via#le #usiness"
160
%3-orting $ay also #e suita#le +or s-ecialist -roucts an services, that $ay
have a li$ite $arket"
2or e3a$-le, so$e s-ecialise ite$s o+ e&ui-$ent are $anu+acture in lo!
volu$es in a +e! -laces aroun the !orl, an e3-orte to custo$ers that use
the e&ui-$ent, !herever they $ay ha--en to #e"
5.1!.3. E)porting & bran. operations
International activity $ay +all into t!o categories"
The +irst involves e3-orting -roucts or services"
In these cases, the #usiness $ay continue to o-erate as #e+ore, #ut si$-ly
eal !ith custo$ers in +oreign countries"
This $ay a--ly to $anu+acturing o-erations, although it $ay also a--ly to
services"
2or e3a$-le, -er+or$ing services +or overseas clients is a co$$on situation
in the case o+ contract engineering, !hich $ay involve co$-le3 -rouct
evelo-$ent or large construction -ro9ects"
5.1!.4. +on(itions for e)pansion
%3-ansion $ay #e a via#le o-tion !hen a #usiness is generating strong
-ositive cash +lo!"
In so$e cases, e3-ansion $ay #e -ursue in an atte$-t to solve -ro#le$s
!ithin the #usiness o-erations"
2or e3a$-le, a $anu+acturer $ay have e3cess -rouction ca-acity an high
+i3e costs, an $ay nee to e3-an sales into overseas regions in orer to
generate su++icient sales to #reak even"
=o!ever, e3-ansion $ay re&uire a signi+icant invest$ent o+ ca-ital an
ongoing cash +lo!, an $ay -lace a signi+icant rain on the #usiness +or an
e3tene -erio o+ ti$e"
161
I+ a #usiness is e3-eriencing internal -ro#le$s that cannot #e solve -urely
#y increasing volu$es, then in general these -ro#le$s $ay nee to #e
aresse #e+ore an e3-ansion -rogra$ is consiere"
In aition to strong -ositive cash +lo!, a range o+ -roucts or services that
!ere success+ul an $ay $eet !ith a e$an +ro$ custo$ers in a +oreign
$arket $ay #e neee +or a success+ul e3-ansion -rocess"
5.1!.5. +apital
%sta#lishing an overseas o-eration or custo$er #ase $ay involve a
consiera#le ca-ital cost"
/a-ital $ay nee to #e s-ent very care+ully uring this -rocess"
In so$e cases, a #usiness $ay atte$-t to esta#lish an overseas o-eration,
only to +in that the availa#le ca-ital is &uickly consu$e"
This -rocess $ay en !ith the #usiness !ithra!ing to the original
o-eration, having s-ent a consiera#le -ortion o+ the #usinessCs ca-ital +or no
lasting result"

5.1!.!. +.oie of loation
The choice o+ location $ay e-en on issues such as language, e3change
rates, the e$an +or the -rouct or service, co$-etitors an the general
rece-tiveness to +oreign o-erations"
In so$e cases, a country that is geogra-hically close to the e3isting #usiness
o-eration $ay #e chosen as the +irst -lace +or an international o-eration"
This $ay have #ene+its in ter$s o+ a reuce cost o+ air travel, reuce
shi--ing costs, an reuce -ro#le$s !ith i++erent ti$e @ones in
co$-arison to $ore istant locations"
=o!ever, in $any cases the $ost suita#le location $ay #e a location that is a
consiera#le istance a!ay +ro$ the #ase location"
In so$e cases, regions !ith the greatest si$ilarity to the ho$e country o+ the
#usiness $ay #e on the o--osite sie o+ the !orl"
162
2or e3a$-le, Australian econo$y has so$e si$ilarities to the econo$ies o+
/anaa an South A+rica", -articularly in ter$s o+ the $ining inustry"
=o!ever, geogra-hically these other t!o countries coul not #e +urther
a!ay"
5.1!.7. Distribution
Sales to overseas custo$ers $ay involve issues o+ shi--ing costs an
shi--ing arrange$ents, +oreign currency conversion, language, custo$s, an
govern$ent -er$its an restrictions"
These are -ractical -ro#le$s that $ay #e aresse as -art o+ the #usiness
o-eration"
A $a9or challenge in $any cases $ay involve istri#ution, an
co$$unicating e++ectively !ith -otential custo$ers"
A range o+ -ossi#ility a--roaches $ay e3ist +or istri#uting -roucts !ithin
+oreign countries"
5.1!.7.1.Diret ontat
7irect a--roaches to overseas custo$ers $ay #e +easi#le in cases !here the
#usiness eals !ith a s$all nu$#er o+ large transactions, or eals !ith other
#usiness o-erations"
2or e3a$-le, irect a--roaches $ay #e $ae to the #uyers o+ large retail
chains"
In the case o+ -ro9ects, teners coul #e su#$itte to clients in overseas
locations"
In ter$s o+ $arketing to the general -u#lic, this $ay #e +easi#le i+ a s$all
region !as chosen as the initial #ase"
=o!ever, atte$-ting to esta#lish a retail -resence !ithin a $a9or $arket,
using an a--roach such as a general avertising ca$-aign, $ay result in the
availa#le ca-ital #eing ra-ily consu$e !ithout creating a sustaina#le level
o+ sales"
163
5.1!.7.2.8oal operations
A local o-eration $ay involve esta#lishing a #ranch o++ice o+ the #usiness in
an overseas location"
This $ay o-erate as a istri#utor o+ the #usinessCs -roucts or services"
In other cases, -articularly !ith services, the #ranch $ay o-erate as a stan<
alone o-eration that !as ine-enent o+ the $ain #usiness"
These o-erations $ay generate a negative cash +lo! +or a consiera#le -erio
o+ ti$e, an $ay have to #e +une #y the $ain #usiness until they reache a
#reak<even -oint"
5.1!.7.3.>oint ventures & (istribution agreements
A 9oint venture or thir<-arty istri#ution arrange$ent $ay involve a
#usiness !ithin the +oreign country #eco$ing a istri#utor o+ the -roucts"
This $ay a--ly in cases !here the #usiness -rouce a uni&ue -rouct that
!as not generally availa#le +ro$ other sources, +or e3a$-le"
5.1!.7.4.Overseas 4mporters
A istri#ution alternative that $ay involve lo! costs +or the #usiness $ay
involve an i$-orter !ithin the +oreign country i$-orting an istri#uting the
#usinessCs -roucts"
This $ay involve a regular shi-$ent to a single elivery -oint, an $ay
avoi $any co$-lications an e3-enses that $ay #e involve in ealing !ith
a large nu$#er o+ iniviual custo$ers"
This o-tion $ay #e availa#le !hen a -rouct that is attractive an cost<
e++ective is availa#le, an !oul #e attractive to i$-orters an +oreign
custo$ers"
160
5.1!.7.5.On*line aess
An<line access to the #usiness -roucts, through $ethos such as the
Internet, $ay #e a $a9or co$-onent o+ international sales, -articularly in the
case o+ retail -roucts that are sol irectly to the general -u#lic"
In the case o+ so$e s-ecialty ite$s, a #usiness $ay +in that the $a9ority o+
orers co$e +ro$ overseas custo$ers, !ith very +e! ite$s #eing -urchase
#y local custo$ers"
An on<line -resence $ay have a #ene+it over other istri#ution a--roaches, in
that no aitional cost or evelo-$ent $ay #e involve in $aking the
-roucts availa#le to custo$ers in overseas countries"
In contrast, $ethos such as avertising ca$-aigns $ay involve consiera#le
cost, an $ay nee to #e organise se-arately +or each -articular region"
Internet !e# sites $ay #e esta#lishe +or relatively little cost"
=o!ever, in the case o+ co$-lete sites involving large -rouct lists, an
integrate orering, stock $anage$ent an re-orting syste$s, a consiera#le
cost $ay #e involve in creating an $aintaining the on<line site"
Su--lying overseas custo$ers in this situation $ay not #e signi+icantly $ore
i++icult than su--lying local custo$ers"
2oreign currency -ay$ents $ay #e acce-te, although these -ay$ents can #e
$ae through electronic -ay$ent $ethos, an $ay not #e i++icult to
i$-le$ent"
Shi--ing etails $ay #e i++erent +ro$ local orers, ho!ever shi--ing costs
$ay #e -ai #y the custo$er, an shi--ing arrange$ents $ay not #e i++icult
to organise"
7isavantages !ith on<line istri#ution $ay inclue that +act that traitional
activities, such as avertising, $ay also #e neee to generate sales, in
aition to si$-ly creating an on<line istri#ution site"
5.1!.8. +lose( mar6ets
Many countries have a range o+ restrictions an regulations concerning
i$-orte goos, an overseas involve$ent in asset o!nershi- an #usiness
transactions"
16*
In so$e cases, these situations $ay #e aresse through a long -rocess o+
gaining authorisation +ro$ govern$ent e-art$ents to allo! e3-orting to
custo$ers !ith the +oreign country, an to conuct #usiness activities !ithin
that country"
In other cases, $ore su#tle -ro#le$s $ay arise, ue to i++erent custo$ary
transactions an arrange$ents in #usiness activity co$-are !ith the ho$e
country"
5ro#le$s such as these $ay #e reuce through arranging a 9oint venture
activity !ith a local #usiness !ithin the other country"
This $ay involve another #usiness istri#uting the -roucts to local
custo$ers, or arranging #usiness transactions in co$#ination !ith the
#usiness itsel+"
An a larger scale, a si$ilar -rocess $ay involve -urchasing a #usiness !ithin
an overseas country, an using the #usiness +or istri#ution o+ the -roucts,
o+ +or conucting the services that are -er+or$e #y the $ain #usiness"
5.1!.9. /oreign e).ange issues
/onucting international o-erations $ay involve ealing !ith +oreign
currencies, an this $ay involve a nu$#er o+ issues"
/onversion #et!een +oreign currencies an Australian ollars is a
straight+or!ar -rocess an this service is -rovie #y $ost $a9or #anks"
5.1!.9.1.E).ange rates
In so$e cases, the e3change rate #et!een t!o currencies $ay #e a +i3e rate,
as eclare #y a govern$ent regulation"
This $ay occur in the case o+ so$e s$all counties !hich $ay tie their
currency to the value o+ a $a9or international currency"
=o!ever, this is a co$-aratively rare situation"
A regulation cannot alter the e++ect o+ econo$ic +orces"
16)
The value o+ a currency $ay #e eter$ine #y the a$ount o+ currency on
issue, an the assets hel !ithin the country o+ issue"
This $ay create a natural level +or the currency e3change rate, an atte$-ts
to +orce transactions to occur at an altere level $ay #e unsustaina#le on a
long ter$ #asis"
Most e3changes rates at the ti$e o+ !riting are +loating, an $ay vary in a
si$ilar -attern to the -rice o+ other $arket co$$oities such as shares,
$ining co$$oities, an agricultural co$$oities"
%3change rate levels $ay #e volatile, an changes $ay occur in a rano$
-attern"
Although atte$-ts $ay #e $ae to +orecast or -reict long ter$ trens in
e3change rates, in general it $ay #e assu$e that +uture e3change rate levels
cannot #e accurately -reicte"

5.1!.9.2.3riing
5ay$ent $ay #e re&ueste in the #usinessCs ho$e currency, or -ay$ent $ay
#e acce-te in a +oreign currency"
Acce-ting +oreign currency -ay$ents $ay reuce the -ossi#ility o+ lost sales
ue to i++iculties !ith the custo$er arranging a +oreign currency transaction"
=o!ever, this alternative $ay also re&uire a +re&uent u-ating o+ -rice lists,
to re+lect changes in e3change rates"
%3change rates $ay change on a aily #asis"
In cases !here a -rice is &uote in a local currency, a -rice $ay #e &uote to
a custo$er +or a s-eci+ic transaction on a s-eci+ic ate"
Alternatively, a +i3e -rice $ay #e liste, an -rices $ay #e u-ate !hen a
su#stantial rise or +all in the e3change rate occurs"
168
5.1!.1". -anaging e).ange rate ris6
5.1!.1".1. Offsetting e)posures
In so$e cases, the e++ect o+ e3change rate $ove$ents $ay #e reuce #y
holing e3-osures that act in o--osite irections"
2or e3a$-le, sourcing ra! $aterials +ro$ the sa$e region or in the sa$e
currency as the e3-ort currency $ay reuce the e++ect o+ changing e3change
rates"
In this case, a change in an e3change rate $ay alter #oth the costs an the
inco$e o+ the #usiness, !ith costs an inco$e #oth rising or +alling at the
sa$e ti$e"
This a++ect $ay reuce the i$-act o+ e3change rate $ove$ents on the cash
+lo! an net -ro+it o+ the #usiness"
In so$e cases, assets $ay #e hel in overseas countries"
2or e3a$-le, a storage !arehouse $ay #e o!ne in a +oreign country, an
use +or the storage o+ goos -rior to istri#ution to custo$ers"
In these situations, the value o+ the asset in the local currency $ay change in
line !ith changes in the e3change rate"
This risk $ay #e reuce #y holing e#t in the sa$e currency as the asset"
/hanges in the value o+ the e#t $ay o++set changes in the value o+ the asset,
leaing to a reuce e3-osure o+ net assets to the e3change rate"
7e#t coul #e raise to -urchase or construct an asset"
In other cases, e#t coul #e raise in a +oreign currency, converte to the
local currency, an -lace on e-osit"
This transaction $ay #e use as a general long<ter$ hege against changes in
+oreign asset e3-osures"
161
5.1!.1".2. /utures an( for5ar( sales
In the case o+ s-eci+ic large transactions, a +oreign e3change +utures contract
or a +or!ar contract $ay #e use to reuce the risk o+ an averse change in
a +oreign e3change rate"
2or e3a$-le, a large ite$ o+ e&ui-$ent $ay #e orere #y an overseas
custo$er, +or elivery in t!elve $onthCs ti$e"
In this situation, a +utures contract coul #e entere to ena#le a +oreign
e3change transaction to #e conucte on a +uture ate, !ith the e3change rate
to #e +i3e at the current level"
These $ethos $ay #e use to $anage cash +lo! changes an the e3-osure
to s-eci+ic transactions"
=o!ever, +utures a--ly over a s-eci+ic -erio o+ ti$e, an cannot #e use to
hege long ter$ trens in currency values"
5.1!.1".3. ,eporting issues
5roucing +inancial state$ents an other re-orting $ay involve several
issues !hen +oreign o-erations are involve"
The value o+ assets an lia#ilities $ay #e translate into the local currency o+
the #usiness +or the -ur-ose o+ -re-aring a #alance sheet"
,arge changes in net assets $ay occur ue to changes in e3change rates, an
in so$e cases a :+oreign currency translation reserve; $ay #e inclue
!ithin the net assets +igure to re+lect the change in net assets that is ue to a
change in e3change rates"
In the case o+ e3-orts o+ -roucts, i$-orts o+ su--lies, an o-erations in
+oreign countries, large rises an +alls in sales, cash +lo! an net -ro+it $ay
occur +ro$ one -erio to the ne3t, ue to changes in currency e3change rates"
#.1). 2nsolvency an( li4ui(ation
5.17.1. 4nsolven$
166
Insolvency occurs !hen a #usiness is una#le to $eet a -ay$ent that is ue"
This $ay result in a restructure o+ the #usinesses #y a receiver, an the
#usiness $ay trae out o+ the situation an continue o-erating"
In general, ho!ever, this situation $ay result in the assets #eing sol an the
#usiness #eing !oun u-"
In the case o+ an iniviual this -rocess is kno!n as #ankru-tcy, !hile in the
case o+ a #usiness it is kno!n as li&uiation"
5.17.2. T.e ris6 of insolven$
The risk o+ insolvency occurring $ay #e a signi+icant risk in $any #usiness
activities"
In the case o+ an iniviual, assets $ay o+ten #e sol an e3-enses $ay #e
reuce in ti$es o+ lo! inco$e or +inancial i++iculty"
In the case o+ a #usiness, ho!ever, #oth the assets an the e3-enses $ay #e
necessary in orer to generate the #usiness inco$e"
A lo! level o+ sales, a co$-le3 an ine++icient #usiness structure, or a lack o+
e++ective -roucts or services $ay lea to negative cash +lo! an eventually
the li&uiation o+ a #usiness"
5.17.3. +on(itions for insolven$
Insolvency occurs !hen a #usiness cannot $eet a -ay$ent that is ue"
This situation $ay arise in various circu$stances"
#egative cash flow
4egative cash +lo! involves $oney +lo!ing out o+ the #usiness at a larger
rate than $oney is +lo!ing into the #usiness"
4egative cash +lo! oes not i$-ly insolvency, as long as there is su++icient
cash availa#le to -ay e3-enses as they #eco$e ue"
600
=o!ever, negative cash +lo! is an unsustaina#le situation, as the net assets o+
the #usiness !oul eventually #e reuce to @ero"
#egative e)uit*

Also, negative e&uity oes not i$-ly insolvency"
4egative e&uity, also kno!n as negative net assets, occurs !hen the e#ts o+
the #usiness are larger than the assets, an in theory the net value o+ the
#usiness is negative"
4egative e&uity $ay suggest that the #usiness is e3-eriencing serious
+inancial -ro#le$s"
In this situation, the interest e3-ense $ay #e high in -ro-ortion to o-erating
inco$e"
=o!ever, a #usiness $ay continue o-erating !ith negative net assets, as long
as there is su++icient cash to $eet -ay$ents as they #eco$e ue"
In the case o+ negative cash +lo!, the availa#le cash reserves $ay eventually
#e reuce to @ero, an the #usiness $ay #eco$e insolvent"
In the case o+ -ositive cash +lo!, assets $ay accu$ulate !ithin the #usiness
structure an the e&uity value $ay eventually #eco$e -ositive"
Cash "alances
A #usiness $ay have -ositive cash +lo!, -ositive net assets, an yet still
#eco$e insolvent"
This coul occur !hen a large -ay$ent is ue, ho!ever there is insu++icient
cash availa#le to $eet the -ay$ent"
Insolvency $ay arise ue to a lack o+ availa#le cash, rather than a lack o+
assets"
5.17.4. ,easons for business failure
Businesses $ay cease to o-erate +or a !ie range o+ reasons"
601
=o!ever, so$e o+ the $a9or causes $ay inclue so$e o+ the +ollo!ing
ite$s"
1" %3cessive e#t
Many #usiness +ailures are associate !ith a high level o+ e#t"
Ather reasons such as slo! sales $ay contri#ute to the +inal result, ho!ever
the #uren o+ e#t -ay$ents $ay #e the trigger that leas to the actual
insolvency"
2or e3a$-le, e#t $ay #e raise to +un e3-ansion"
The costs o+ $arketing activities, e3-aning +acilities an evelo-ing
-roucts $ay lea to the ca-ital #eing consu$e an +e! assets #eing
create, ho!ever the si@e o+ the e#t $ay re$ain unchange"
In so$e situations, a -erio o+ slo! sales $ay occur, an cash +lo! an asset
values $ay ecline"
Aver ti$e, the #usiness $ay #e le+t !ith a high e#t level, +e! assets, an
$ay #e una#le to $eet e#t -ay$ents as they #eco$e ue"

2" 7eclining inustries an unco$-etitive -roucts
Dhile so$e areas o+ the econo$y an inustries e3-an, others $ay ecline
over ti$e"
2or e3a$-le, at the ti$e o+ !riting, $anu+acturing is in long<ter$ ecline,
!hile service #usinesses are a gro!th area o+ the econo$y"
Businesses o-erating in eclining inustries $ay nee to -urchase other
#usinesses an continually reinvest in u-ate -rouction -rocesses, in orer
to $aintain sales levels an to ensure that costs re$ain #elo! the -rice levels
that $ay #e set #y the custo$er interest in the -roucts"
3" 5oor $anage$ent
Business +ailures are o+ten associate !ith -oor $anage$ent o+ the #usiness
o-eration"
Recors $ay #e -oorly ke-t an in+or$ation $ay #e $onths out o+ ate"
602
Basic accounting an #usiness in+or$ation $ay #e store in a range o+
i++erent syste$s an $ay not #e reaily availa#le, an transactions $ay #e
conucte on a rano$ #asis, rather than #eing -art o+ a clear #usiness
irection"
0" =igh cost structures
In so$e #usiness situations, high cost levels $ay lea to negative cash +lo!
an eventually insolvency"
=igh costs $ay arise through so$e o+ the +ollo!ing circu$stances"
Autate e&ui-$ent an ine++icient -rouction -rocesses"
%3cessive sta++ levels +or the activities #eing -er+or$e"
7istri#ution channels in !hich +ees are receive !ithout signi+icant
#ene+it #eing ae to the istri#ution -rocess"
,o! volu$es, leaing to a lack o+ econo$ies o+ scale, an +i3e
costs #eing s-rea across a s$all nu$#er o+ -roucts or
transactions"
A -oorly structure #usiness o-eration, !ith u-licate an
overla--ing +unctions, an a range o+ +unctions #eing -er+or$e that
o not result in an e++icient #usiness activity occurring"
*" Averly a$#itious -ro9ects
In so$e situations, a #usiness $ay initiate a -ro9ect that is too large +or the
#usiness to sustain"
2or e3a$-le, this $ay involve an overseas e3-ansion, a large evelo-$ent
-ro9ect such as a ne! -rouct, or general e3-ansion at an e3cessive rate"
In these cases the -ro9ect $ay #e -artially co$-lete"
The #usiness $ay have insu++icient ca-ital to co$-lete the -ro9ect, an the
#usiness $ay #e li&uiate, !ith the -ro9ect never #eing co$-lete"
603
5.17.5. ,eeivers.ip
Dhen a co$-any is una#le to $eet -ay$ents that are ue, a receiver $ay #e
is a--ointe to take control o+ the #usiness"
This a--oint$ent is orere #y a court"
An a--lication can #e $ae to the court #y a creitor o+ the co$-any, !hich
involves any -arty that is o!e $oney #y the #usiness an !here -ay$ent
has not #een $ae #y the ue ate"
Also, a #usiness $ay voluntarily re&uest that a receiver #e a--ointe"
The receiver $ay assess the conition o+ the #usiness"
This -rocess $ay lea to a ecision to continue o-erating the #usiness an
atte$-t to trae out o+ the situation, or to orer that the #usiness #e !oun u-
an li&uiate"
This assess$ent $ay #e $ae &uickly an $ay generally occur !ithin a
-erio o+ a +e! !eeks"
The -roceures +or #ankru-tcy, receivershi- an li&uiation are set out in
etail in the co$$ercial la! legislation"
A ecision to continue traing $ay only occur !hen the receiver ca$e to the
vie! that the #usiness coul continue to o-erate !ithout incurring +urther
e#ts, an !hen there !as a reasona#le chance that traing conitions !oul
i$-rove signi+icantly"
I+ this !as not the case, then a li&uiator $ay #e a--ointe to li&uiate the
#usiness
5.17.!. 8i9ui(ation
,i&uiation involves selling the assets o+ the #usiness, re-aying the e#ts o+
the #usiness, an istri#uting any re$aining +uns to the #usiness o!ners"
Secure e#ts are e#ts that are secure against a s-eci+ic asset, such as a
$ortgage o+ a -ro-erty"
600
Hnsecure e#ts are all other e#ts o+ the #usiness that are not secure
against a s-eci+ic asset"
The li&uiator arranges the sale o+ the assets"
Secure creitors are re-ai the +ull a$ount o+ the e#t, i+ the sale o+ the
secure asset raise a su++icient a$ount to re-ay the e#t"
Any e3cess a$ount that is raise +ro$ the sale o+ an asset that is use as
security +or a e#t is trans+erre into the general -ool o+ +uns"
I+ the a$ount o+ $oney that is raise +ro$ the sale o+ an asset that is use +or
security is not su++icient to re-ay the entire e#t, then the re$aining e#t
#eco$es -art o+ the -ool o+ unsecure e#ts"
A+ter the asset sales have #een co$-lete, the availa#le +uns are use to
re-ay the unsecure creitors on a -ro<rata #asis"
In general, the +uns $ay #e istri#ute so that each e#t is re-ai to the
sa$e level o+ -ercentage re-ay$ent as the other e#ts"
=o!ever, there $ay #e so$e li$ite e3ce-tions, such as the +act that the
receiverCs an li&uiatorCs +ees are -ai in +ull #e+ore the +uns are
istri#ute to creitors"
Any aitional +uns that re$ain a+ter the li&uiation has #een co$-lete are
istri#ute to the #usiness o!ners on a -ro<rata #asis, accoring to their
shareholing"
5.17.7. 'voi(ing 4nsolven$
The risk o+ insolvency occurring $ay #e reuce #y +ollo!ing a nu$#er o+
ste-s"
These $ay inclue so$e o+ the +ollo!ing issues"
(nsuring that assets are conservativel* valued
This -articularly a--lies to intangi#le assets such as #ran na$es an
licences"
60*
/onservative valuations $ay -revent the #usiness +ro$ taking on e3cessive
e#t or overly a$#itious -rogra$s, ue to unrealistic valuations -lace on
assets"
This also $ay also result in a realistic assess$ent #eing $ae o+ the +uns
that coul #e raise i+ asset sales !ere re&uire"
Avoiding e%cessive de"t
A #usiness $ay eteriorate ra-ily, !ith a #usiness that a--eare to #e in a
sta#le +inancial -osition eteriorating to near insolvency in a $atter o+
$onths"
This $ay occur in situations such as a shar- ro- in sales occurring, or $ay
#e ue to an event such as an asset valuation !rite<o!n"
Many #usiness o-erations re&uire a certain level o+ e#t in orer to o-erate
e++ectively"
=o!ever, high e#t levels $ay -resent a constant risk to the #usiness, an
care shoul #e taken in allo!ing a high e#t level to -ersist !ithout ste-s
#eing taken to reuce the e#t"
/anaging the "usiness effectivel*
%++ective $anage$ent $ay involve care+ul cost control, collection o+ e#ts,
$aintaining an e++icient o-eration an evelo-ing ne! -roucts an services
+or the +uture"
/aintaining ade)uate levels of cash
A #usiness $ay cease to o-erate ue to a short<ter$ cash +lo! -ro#le$"
This $ay occur !hen the #usiness o-eration itsel+ is soun an !oul have
continue to o-erate success+ully, ha it not #een +or a te$-orary cash +lo!
-ro#le$"
Total asset values $ay involve $any other assets in aition to availa#le
cash #alances"

60)
A #usiness $ay have signi+icant assets, such as e&ui-$ent an +acilities,
ho!ever the #usiness $ay #eco$e insolvent unless it $aintains su++icient
li&ui assets to $eet -ay$ents that $ay #eco$e ue"

,i&ui assets that $ay #e accessi#le on short notice $ay inclue cash hel in
#ank accounts, creit such as overra+ts, an traa#le li&ui assets such as
shares"
(nsuring that margins are ade)uate
4arro! $argins o+ net inco$e to sales $ay -resent a risk to the #usiness in
the case o+ a sales ecline"
This issue $ay -articularly a--ly in the case !here the costs are +i3e costs
that o not change !ith -rouction levels, such as #uiling rents"
Addressing cash flow as well as profit issues
A #usiness $ay recor a -ro+it ue to rising asset values, or #ooking a large
nu$#er o+ creit sales, even through actual cash +lo! $ay #e lo!"
5ro+it relates to the long ter$ gro!th o+ the #usiness, !hile survival an
insolvency are -ri$arily cash +lo! issues"
-aking action to stem negative cash flow
In so$e cases large negative cash +lo! $ay occur ue to +uning a -ro9ect
that has continue -ast the e3-ecte co$-letion ate, or an o-eration !ith
large e3-enses an a lo! level o+ sales"
Situations such as these $ay nee to #e care+ully $onitore, an !here
necessary action $ay #e neee to reuce or eli$inate the out+lo! o+ +uns,
!hile these o-tions are still availa#le"
5.17.8. 8iabilit$ for (ebts
In the case that insu++icient +uns are raise +ro$ asset sales to re-ay the
e#ts in +ull, several situations $ay occur"
A co$-any is a generally a li$ite lia#ility structure"
608
In this situation, any re$aining e#ts are cancelle"
The shareholers are then not lia#le to contri#ute aitional +uns to!ars
the e#ts o+ the #usiness"
In the case o+ a -artnershi- or a #usiness conucte in a -ersonal na$e, the
#usiness o!ners $ay generally #eco$e -ersonally lia#le +or the re$aining
e#ts"
These e#ts !oul then #e re-ai +ro$ -ersonal assets"
I+ this !as not -ossi#le irectly, then a -ersonal #ankru-tcy $ay result"
In the case o+ a s$all enter-rise, a #ank $ay re&uire irectorCs guarantees
#e+ore they are !illing to loan $oney to the #usiness"
A guarantee $ay a--ly to a s-eci+ic loan, in !hich case the guarantor $ay #e
-ersonal lia#le +or that -articular loan, #ut not +or the re$aining e#ts o+ the
#usiness"
In the case o+ a -ersonal assets o++ere as security +or a #usiness loan, the
-ersonal asset $ay #e sol to re-ay the loan, ho!ever any e3cess value +ro$
the asset sale, an other -ersonal assets, !oul not #e use to $eet the
#usiness e#ts in the case o+ a co$-any structure"
5.17.9. Ban6rupt$
5ersonal #ankru-tcy +ollo!s a si$ilar -rocess to li&uiation, !ith the
iniviualCs assets #eing sol an the -rocees #eing use to re-ay the
outstaning e#ts"
In the case o+ #ankru-tcy, all inco$e earne #y the #ankru-t +or the
+ollo!ing three years is also sei@e an istri#ute to creitors, although the
iniviual $ay retain a s$all living allo!ance"
#.1-. *is+ an( loss in business an( investment
The -ossi#ility o+ loss is a +una$ental ele$ent o+ #usiness an invest$ent"
601
In the case o+ lening, a chance $ay e3ist that the $oney that is lent $ay not
#e recovere in +ull"
In the case o+ a #usiness enter-rise, assets that are hel !ithin the #usiness
structure $ay #e lost through a graual ecline in o-erating conitions, or in
so$e cases through a suen event such as the cancellation o+ a $a9or
custo$er orer or a +ire"
A-erating a #usiness as a co$-any $ay allo! -ersonal assets to #e ke-t
se-arately +ro$ the #usiness assets"
=o!ever, in the case o+ a #usiness activity conucte in an iniviualCs o!n
na$e, a -artnershi-, or -ersonal guarantees, a ecline in traing conitions
$ay lea to all the iniviualCs assets #eing lost, an eventually to
#ankru-tcy"
In consiering involve$ent in a #usiness venture, the a$ount o+ the
$a3i$u$ loss that coul #e incurre, an the risk involve in the enter-rise,
$ay nee to #e care+ully consiere #e+ore a ecision is $ae to -rocee
!ith a transaction or a #usiness activity"
5.18.1. 1uarantees
There is no such thing as a :guarantee; in an a#solute sense"
A :guarantee; $eans that a -erson or organisation has $ae a certain
state$ent"
Dhen the ti$e co$es +or the guarantee to #e honoure, this $ay occur or it
$ay not"
A guarantee $ay not #e +ul+ille #ecause the other -arty cannot +ul+il the
guarantee, or it $ay not #e +ul+ille #ecause they choose not to"
The closest situation to a relia#le guarantee in the $oern !orl $ay involve
a -ay$ent that is guarantee #y a sta#le govern$ent !ith strong +inancial
resources"
2or e3a$-le, an invest$ent in a govern$ent #on carries a state$ent on
#ehal+ o+ the govern$ent that they !ill re-ay the -rinci-al on the ue ate"
=o!ever, even in this case the govern$ent itsel+ $ay #e una#le or un!illing
to carry out the action"
606
Although situations o+ this ty-e $ay #e rare, events o+ this nature o occur at
ti$es"
In 166? (>>check year), the Russian govern$ent e+aulte on -ay$ents on
sovereign govern$ent #ons"
In the 1100Cs, (>>check ecae), the A$erican govern$ent ca$e close to
#ankru-tcy, an the oil $agnate F5 Morgan in9ecte +uns into the
govern$ent syste$ in orer to -revent the govern$ent +ro$ #eco$ing
insolvent"
In less ra$atic circu$stances, is-utes $ay arise a#out the legal status o+
various transactions, an -ay$ents that !ere e3-ecte on a certain ate $ay
not #e $ae"
An e3tene -erio o+ ti$e $ay -ass until court cases an negotiations result
in -ay$ents #eing $ae that $ay have #een ue on earlier ates"
A govern$ent #on issue #y a sta#le govern$ent $ay carry very little risk"
=o!ever, the -rinci-al re$ains that a :guarantee; is si$-ly a state$ent that
is $ae #y another -arty, that they !ill -er+or$ a certain action in certain
circu$stances"

A #ank e-osit $ay generally #e very sa+e"
In Australia, #ank e-osits are not guarantee #y the govern$ent"
=o!ever, the #anking syste$ is very sta#le an the +ailure o+ #anks is very
rare, although #ank +ailures have occurre in -revious ti$es"
In the Hnite States, #ank e-osits are insure #y a +eeral insurance sche$e,
u- to a $a3i$u$ o+ HS G100,000 +or a single e-osit" (>> check etails)
The ter$ :guarantee; is so$eti$es use !ith invest$ent sche$es an
-roucts"
This generally oes not $ean a govern$ent guarantee"
Dhen this ter$ is use, it $ay re+er to the +act that the value o+ the
invest$ent !ill not +all, #ase on the stanar o-eration o+ the -rouct"
2or e3a$-le, the rate o+ return $ay vary +ro$ one $onth to another, #ut it
!ill never #e negative an the value !ill not ecline"
610
=o!ever, this arrange$ent is #acke #y the resources o+ the insurance
co$-any or the -arty that arranges the invest$ent"
In the case that the insurance co$-any itsel+ +ails, -art or all o+ the +uns
coul #e lost"
In seeking a highly sa+e invest$ent, a govern$ent #on, or s-litting the
+uns a$ong several $a9or #anks $ay result in an invest$ent !ith very little
risk"
5.18.2. -one$ at ris6
All $oney contri#ute to an invest$ent is at risk"

Money that is loane, $oney that is use to -urchase an invest$ent, an
$oney that it contri#ute to a #usiness venture coul all #e lost"
So$e invest$ents $ay carry a lo! risk o+ losing the entire invest$ent value"
2or e3a$-le, invest$ent in a -ro-erty, invest$ent in the shares o+ so$e
co$-anies, an lening $oney against a secure asset $ay all have a lo!
risk o+ loosing the entire ca-ital"
5.18.3. 8iabilit$ e)ee(ing t.e investment amount
In any lening or invest$ent situation, a -ossi#ility generally e3ists that the
+ull a$ount o+ the invest$ent $ay #e lost"
In so$e circu$stances this a$ount $ay #e the $a3i$u$ a$ount that can #e
lost"
This $ay a--ly in so$e o+ the +ollo!ing circu$stances"
,ening $oney"
Investing in shares in a co$-any"
A!nershi- o+ a -hysical asset"
611
In other circu$stances, a -arty $ay #e e3-ose to the chance o+ a loss that is
larger than the a$ount o+ $oney that they investe in a #usiness venture"
This $ay occur in so$e o+ the +ollo!ing circu$stances"
Business activities carrie out as a -artnershi-, or in the iniviualCs
o!n na$e"
Dhen -ersonal guarantees are given +or #usiness e#ts"
Dhen -ersonal assets are use as security +or #usiness loans"
5assive invest$ents in #usiness enter-rises, !hen the investor
#eco$es legally -art o+ a -artnershi-, rather than o!ning shares in a
co$-any or #eing a lener"
2inancial $arkets erivatives instru$ents, such as +utures an
o-tions"
(eare +inancial transactions, !here e#t is raise to -urchase an
asset"
5.18.4. #tatus of business involvement
/lear ocu$entation o+ loans an invest$ent agree$ents $ay #e use to
ienti+y the status o+ $oney trans+ers as loans or as e&uity invest$ents"
In cases !here $oney is trans+erre #et!een #usiness an -ersonal accounts,
or +uns are contri#ute irectly #y investors !ithout ocu$entation, the
status o+ +uns $ay #eco$e unclear"
This $ay e3-ose a -arty to aitional risk in a #usiness venture"
2or e3a$-le, a su$ o+ $oney $ay #e intene as a loan"
=o!ever, !ithout clear ocu$entation, a court $ay take the vie! that the
iniviual has #eco$e a -artner in a -artnershi- enter-rise"
In this situation, an iniviual $ay #e -ersonally lia#le +or the entire e#ts o+
the enter-rise, an $ay loose a larger a$ount than the +uns that they
intene to loan"
612
7ocu$entation o+ loans an share o!nershi- oes not nee to #e co$-le3 or
to use legal ter$inology, an a short state$ent o+ the -ur-ose o+ a $oney
trans+er $ay #e su++icient to eter$ine !hether an a$ount is a loan or an
e&uity invest$ent"
5.18.5. #eure( Debt
Secure lening involves $aking a loan an holing an asset as security,
such as a $ortgage over a -ro-erty"
A $ortgage over an asset $ay involve a signi+icant a$ount o+
ocu$entation, an a solicitor $ay nor$ally #e consulte to ra! u- the
relevant ocu$ents"
In the case that the #orro!er !as una#le or un!illing to re-ay the +uns, the
asset coul #e sol to recover the +uns"
The use o+ security +or a loan $ay reuce the risk o+ a su#stantial loss
occurring through the loan +uns not #eing recovere"
5.18.!. 3assive investors
A -assive investor contri#utes +uns to a #usiness enter-rise #ut oes not
#eco$e involve in the o-eration o+ the #usiness"
A -assive invest$ent $ay nee to #e care+ully consiere #e+ore it is
unertaken"
The investor in this case $ay have li$ite kno!lege o+ the #usiness
o-eration"
,arge e#ts $ay #e accu$ulate, an the #usiness $ay #e -oorly $anage,
!ithout the situation #eco$ing clear until it is too late to -revent a
li&uiation +ro$ occurring"
Also, unless a loan or a co$-any structure is use, a legal -artnershi- $ay
e3ist, an the investor $ay #e e3-ose to a loss that is larger than their initial
invest$ent"
613
5.18.7. Debt 1uarantees
In so$e cases, an investor $ay sign a #ank guarantee, guaranteeing a loan"
In these situations, the -erson $ay #eco$e lia#le to re-ay the loan -ersonally
i+ the original #orro!er is una#le or un!illing to $eet the re-ay$ents"
5.18.8. 'tive business o5ners
In the case o+ active #usiness o!ners, the #est e+ence against the risk o+ loss
$ay #e the care+ul $anage$ent o+ the #usiness to -revent insolvency +ro$
occurring in the +irst -lace"
The use o+ a co$-any structure $ay li$it -otential losses to the assets o+ the
#usiness, rather than e3tening to aitional -ersonal lia#ility"
In the case o+ #ank loans !ithin s$all an $eiu$ si@e #usinesses, #anks
$ay re&uire -ersonal guarantees #e+ore e3tening creit"
In -ractice there $ay #e little that can #e one to avoi this a-art +ro$
avoiing e#t co$-letely, an in $any situations a level o+ e#t $ay #e
necessary to continue o-erating the #usiness an to +un ne! -ro9ects"
5.18.9. Being sue(
A-art +ro$ e#t, the other $a9or risk o+ +inancial loss $ay involve #eing
sue"
This $ay involve another -arty taking legal action against the #usiness or an
iniviual to recover +uns"
In the case o+ a #reach o+ contract, the #usiness $ay #e sue #y another -arty
to a co$$ercial arrange$ent"
2or e3a$-le, a -ro9ect $ay #e conucte or an ite$ o+ e&ui-$ent $ay #e
orere, !ith the result that !as elivere not $atching the result that !as
e3-ecte"
,egal action $ay result in long ti$e elays, high legal costs, an large
-ay$ents #eing a!are against the #usiness in the event o+ a lost case"
610
The risk o+ these situations arising $ay #e reuce through so$e o+ the
+ollo!ing ste-s"
%nsuring that contracts an arrange$ents are su--orte #y clear an
etaile ocu$entation"
/hecking !ith su--liers an custo$ers on a regular #asis to ensure
that -ro#le$s are not evelo-ing"
Avoiing contract conitions !hich coul lea to a large loss +or the
#usiness i+ events occurre that !ere outsie the control o+ the
#usiness, such as a su--lier +ailing to su--ly an essential -art +or a
$achine"
,egal action $ay #e taken against irectors an trustees #y shareholers or
#ene+iciaries, on the #asis o+ negligence in +ul+illing the -osition o+ a irector
or a trustee"
The $a9or e+ence against an action o+ this ty-e $ay involve #eing a#le to
e$onstrate that the uties o+ the -osition !here ae&uately carrie out"
,egal action $ay #e taken against the #usiness #y a custo$er, e$-loyee, or
$e$#er o+ the -u#lic !ho su++ers an in9ury in relation to the #usiness
activity, -roucts or -re$ises"
The $a9or e+ence against an action o+ this ty-e $ay #e to e$onstrate that
an unsa+e situation or -rouct ha not #een create through the actions or the
inaction o+ the #usiness"
5.18.9.1.8egal ation 4nsurane
In so$e cases, insurance $ay #e use to reuce the risk o+ a large loss
occurring as a result o+ a legal action"
5ro+essional ine$nity insurance $ay cover so$e situations involving #eing
sue +or negligence"
This insurance $ay #e availa#le +or irectors, trustees an -ro+essional
occu-ations"
61*
5u#lic lia#ility insurance $ay cover so$e situations involving in9ury to the
-u#lic, such as a custo$er in9uring the$selves !hile in the #usiness
-re$ises"
#.1.. 2n(ustry Structure
The structure o+ an inustry $ay have large i$-act on the -ossi#ilities +or
+or$ing a ne! #usiness that o-erates !ithin the inustry"
Inustry structure $ay also a++ect the +uture irections that $ay #e availa#le
to a #usiness that o-erates !ithin the inustry"
5.19.1. /ragmente( in(ustries
So$e inustries $ay #e highly +rag$ente, !ith a large nu$#er o+ se-arate
s$all enter-rises"
Many service inustries that eal !ith the general -u#lic +all into this
category"
%sta#lishing a ne! #usiness !ithin a +rag$ente inustry $ay #e a relatively
straight+or!ar task"
This $ay involve o-erating as a sole traer, a -artnershi-, or a s$all
o-eration involving a traitional #usiness structure"
Avertising or contacts +ro$ -revious o-eration !ithin an inustry $ay #e
use+ul in so$e circu$stances in esta#lishing a client #ase"
A nu$#er o+ o-tions $ay #e availa#le +or gro!th !ithin a +rag$ente
inustry"
1rganic growth
The #usiness $ay increase the nu$#er o+ e$-loyees or contract sta++, an
e3-an o-erations through increasing the volu$e o+ services or -rouction"
=o!ever, e3-aning custo$er nu$#ers using this a--roach in a +rag$ente
inustry $ay #e a i++icult o-tion"
61)
In these inustries, econo$ies o+ scale o not usually e3ist"
In the case o+ a $anu+acturing o-eration, the cost -er unit generally eclines
as the volu$e o+ -rouction is increase"
In a service #usiness such as a -ro-erty services #usiness, ho!ever, the cost
o+ -roviing the service $ay not alter signi+icantly !ith the si@e o+ the
#usiness"
2or e3a$-le, a real estate agency that contracte 100 real estate agents $ay
have a si$ilar cost -er hour o+ services to an agency that e$-loye 10
agents"
In so$e cases, cost<-er<transaction $ay actually increase as volu$es rise,
ue to an increase i++iculty !ith coorination in a large organisation, $ore
co$-le3 an e3-ensive a$inistration syste$s, an so on"
Avertising an -ro$otion to increase sales levels $ay involve consiera#le
cost, an in the a#sence o+ econo$ies o+ scale, the increase in sales $ay not
#e su++icient to o++set the costs that $ay #e involve in organic e3-ansion"
Purchasing other "usinesses
Another alternative +or e3-ansion $ay involve #uying another #usinesses or
-ro+essional -ractice as a $etho o+ increasing the nu$#er o+ custo$ers or
clients"

This $etho $ay #e use in -ro+essional service inustries"
In this arrange$ent, a -ay$ent $ay #e $ae to the -urchase #usiness to
ac&uire the client #ase, the clients $ay #e trans+erre to the #uying #usiness,
an the o-erations o+ the -urchase #usiness $ay #e integrate !ith the
#uying #usiness"
+ranchising
A thir alternative $ay involve #uiling a #ran na$e an a -resence !ithin
a $arket, an then creating a +ranchise #usiness"
This $ay involve licensing the #usiness na$e to ine-enent o-erators, in
return +or an ongoing license +ee"
618
This $etho $ay -articularly a--ly to #usinesses that o-erate !ithin a
li$ite region, !here the sa$e activity is -er+or$e in $any i++erent -laces"
=o$e $aintenance services an +ast<+oo outlets $ay #e e3a$-les o+ this
ty-e o+ #usiness"
In the case o+ an esta#lishe #usiness in a +rag$ente inustry, selling the
#usiness to a ne! o-erator, or to another #usiness !ishing to e3-an, $ay #e
a co$$on e3it strategy"
5.19.2. +onentrate( in(ustries
So$e inustries are highly concentrate, !ith a s$all nu$#er o+
organisations o$inating the inustry"
This $ay occur in ca-ital<intensive inustries, an in inustries in !hich
econo$ies o+ scale occur"
2or e3a$-le, teleco$$unications services is a ca-ital intensive inustry,
re&uiring large ca-ital e3-eniture +or e&ui-$ent an +acilities"
This inustry is o$inate #y a +e! large co$-anies"
Inustries such as $ining, $anu+acturing an #anking $ay #e a++ecte #y
econo$ies o+ scale"
In these cases, the cost -er unit $ay +all as volu$es increase"
This -rocess $ay +ee on itsel+, so that as volu$es increase, costs an -rices
-er unit continually ecline, an eventually the inustry consoliates into a
s$all nu$#er o+ large co$-anies"
%sta#lishing a ne! #usiness !ithin a concentrate inustry $ay #e e3tre$ely
i++icult"
This $ay occur +or several reasons"
7ue to the $assive econo$ies o+ scale in large e3isting o-erations, a s$all
ne! o-eration $ay not #e a#le to -rouce goos +or the sa$e costs as the
e3isting organisations, an so $ay not #e a#le to o++er e&uivalent or lo!er
-rices in orer to attract custo$ers"
611
Also, in these situations, agree$ents #et!een custo$ers, su--liers, an
e3isting #usinesses $ay #e tie u- in long<ter$ agree$ents"
This $ay $ake it i++icult +or a ne! #usiness to esta#lish a custo$er #ase
ue to e3isting agree$ents #et!een custo$ers an su--liers"

Several alternatives $ay #e availa#le in these cases"
A loss leaer a--roach $ay #e use to esta#lish a -resence !ithin an
inustry"
This $ay involve selling -roucts at #elo! the cost o+ -rouction, to #uil an
initial custo$er #ase"
This o-tion $ay re&uire a su#stantial a$ount o+ ca-ital to +un the loss on
the initial sales"
This alternative $ay only #e -ractical !hen there !as enough ca-ital
availa#le to create a sustaina#le level o+ sales, #e+ore the availa#le ca-ital +or
the #usiness esta#lish$ent -rocess !as e3hauste"
Another alternative $ay involve esta#lishing a niche o-eration, to -er+or$ an
unusual service !ithin the inustry, or to +ocus on a s$all section o+
custo$ers !ho !ere not service #y the larger organisations"
This a--roach $ay #e use to create a long<ter$ o-eration irectly"
Also, this a--roach $ay #e use to esta#lish a -resence !ithin an inustry
that $ay lea to the evelo-$ent o+ a $ore traitional range o+ -roucts"
A-erating a large #usiness !ithin a concentrate inustry $ay involve
$aintaining the e++icient o-eration o+ the #usiness"
A-tions +or gro!th $at inclue continue reuction o+ costs through
continuous evelo-$ent o+ technology, e3-aning sales or o-erations to
+oreign regions, an using e3isting cash +lo! to +un ne! o-erations !ithin
other inustries"
5.19.3. +onsoli(ating in(ustries
So$e inustries $ay -ass through a consoliation -hase uring a certain
-erio o+ ti$e"
616
7uring this -erio, the inustry $ay graually $ove +ro$ #eing a
+rag$ente inustry !ith $any s$all o-erations, to a concentrate inustry
!ith a +e! large co$-anies"
The nu$#er o+ #usinesses $ay +all !hile the si@e o+ iniviual #usinesses
$ay gro!"
The consoliation -rocess $ay involve so$e o+ the +ollo!ing activities"
Businesses $erging to +or$ larger organisations"
Businesses #uying other #usinesses"
Businesses eclining in si@e an ceasing to o-erate, or !ithra!ing
+ro$ the inustry"
2or e3a$-le, at the ti$e o+ !riting the raiology inustry in Australia is
unergoing a consoliation -hase (>> check etails)"
Raiology involves ?<rays an other $eial scanning an i$aging
techni&ues"
This inustry has traitionally #een highly +rag$ente, an co$-ose o+ a
large nu$#er o+ s$all raiology -ractices"
5ractices such as these $ay #e o-erate as sole traers or -artnershi-s"
The consoliation -hase $ay involve a nu$#er o+ co$-anies evelo-ing
larger scale raiology #usinesses #y #uying a large nu$#er o+ iniviual
-ractices an -er+or$ing a large volu$e o+ services"
This inustry also has signi+icant ca-ital re&uire$ents +or e&ui-$ent, !hich
$ay -rovie an avantage to larger o-erations through chea-er +uning o+
e&ui-$ent co$-are to s$aller enter-rises, an -ossi#ly lo!er costs<-er<unit
+ro$ large scale e&ui-$ent"
A-erating in a consoliating inustry $ay -resent a nu$#er o+ challenges"
Dhen an inustry consoliates, continuing o-erations uner the sa$e
conitions as #e+ore $ay not #e a via#le o-tion over the long ter$"
A #usiness that continues to o-erate as a s$all enter-rise $ay +in that a +e!
large lo!<cost organisations a--ear !ithin the inustry, an that it cannot
620
o++er the sa$e -rices ue to a higher cost -er unit, cause #y less econo$ies
o+ scale"
In these cases, a #usiness $ay graually loose custo$ers, an $ay ecline in
si@e until it eventually ceases to o-erate"
/ontinuing to o-erate on an ine-enent #asis over the long ter$ $ay #e
-ossi#le in so$e cases, although this $ay lea to very lo! -ro+ita#ility an a
#usiness that survives at a su#sistence level"
In other cases this $ay not #e -ractical an the +lo! o+ custo$ers $ay
si$-ly isa--ear"
Several o-tions $ay #e availa#le in these circu$stances"
A #usiness coul $erge !ith another organisation"
This a--roach $ay have the #ene+it o+ retaining so$e ine-enence, !hile
still increasing the si@e o+ the #usiness to the -oint that the #usiness o-eration
$ay #e sustaina#le over the long ter$"
Alternatively, the #usiness $ay -urchase other #usinesses to e3-an in si@e
an $aintain a sustaina#le o-eration"

=o!ever, this a--roach $ay lea to a $ore traitional #usiness o-eration,
!hich $ay not #e the interest o+ the original #usiness o-erators"
Also, the #usiness $ay acce-t an o++er o+ -urchase +ro$ one o+ the
e3-aning organisations"
2ollo!ing a sale, the #usiness o!ner coul continue to o-erate on a contract
#asis, or coul !ithra! +ro$ the inustry"
5.19.4. 2ig. gro5t. in(ustries
=igh gro!th inustries $ay involve ra-ily rising levels o+ sales, an
increasing volu$es o+ -rouction or service elivery"
Ra-i e3-ansion is not sustaina#le on a long ter$ #asis, an these -erios
$ay en in a crash, or !ith the inustry sta#ilising at a certain si@e"
2ollo!ing the -erio o+ ra-i gro!th, a crash $ay lea to sales +alling to a
lo! level"
621
Alternatively, sales $ay sta#ilise at a -articular level, an gro!th rates $ay
+all to sustaina#le levels"
%3a$-les o+ ra-i e3-ansion $ay inclue the 4ickel $ining #oo$ o+ the
1680Cs (>>check ecae) an the Internet #oo$ o+ the 1660s"
A-erating in a high gro!th inustry $ay -resent $any o--ortunities, #ut
$ay also involve signi+icant -ro#le$s an risks"
2or$ing a ne! #usiness !ithin a high gro!th inustry $ay #e relatively
straight+or!ar"
An iniviual or a s$all grou- that has consiera#le e3-erience !ithin an
inustry $ay co$-ile a #usiness -lan, issue a -ros-ectus, an raise $oney in
a -u#lic +loat"
The ca-ital $ay then #e use to hire e$-loyees an atte$-t to evelo-
-roucts an generate inco$e"
Another scenario $ay involve a co$-any that o-erates in a traitional lo!<
gro!th inustry investing a su$ o+ ca-ital to set u- a ne! ine-enent
o-eration !ithin the high gro!th inustry"
A-erating !ithin a high gro!th inustry $ay involve a ra-i increase in
custo$er nu$#ers an strongly rising sales"
=o!ever, this $ay also #e an e3tre$ely co$-etitive environ$ent"
Many ne! co$-anies $ay #e +or$e an co$-etition +or custo$ers $ay #e
intense"
In these situations, #usinesses $ay nee to evelo- ne! -roucts at a ra-i
rate to re$ain at the +ront o+ evelo-$ent o+ the inustry, an to avoi +alling
#ehin an ceasing to o-erate as custo$ers are lost to co$-etitors"
In high gro!th environ$ents, the li+e cycle o+ -roucts $ay #e $easure in
$onths rather than years"
/o$-anies in a high gro!th environ$ent $ay o-erate !ith negative cash
+lo!"
,arge research an -rouct evelo-$ent tea$s $ay #e set u-, an large
a$ounts o+ ca-ital $ay #e s-ent evelo-ing ne! -roucts an e3-aning
+acilities"
622
The inco$e +ro$ sales $ay not #e su++icient to cover this cash out+lo!"
In these situations, the co$-any $ay raise aitional ca-ital +ro$ -u#lic
share issues on a regular #asis"
In the case o+ o-erations set u- #y e3isting co$-anies, lu$- su$s o+ ca-ital
$ay #e trans+erre into the ne! #usiness as the e3isting ca-ital is consu$e"
Alternatively, the ne! #usiness $ay #e +une using cash +lo! +ro$ the
e3isting #usiness o-erations"
Manage$ent o+ a #usiness !ithin a high gro!th inustry $ay involve several
issues"
The #usiness $ay nee to evelo- ne! -roucts an +acilities continually to
re$ain at the +ront o+ the inustry, other!ise the #usiness $ay +all #ehin the
evelo-$ent o+ the inustry, an eventually close"

4egative cash +lo! an regular ca-ital raisings $ay #e inevita#le, an $ay
#e acce-te as -art o+ the e3-ansion -hase"
This $ay not -resent a i++iculty as long as the #oo$ conitions continue"
The #usiness $ay nee to care+ully -re-are +or the crash or ra-i slo!ing
that !ill inevita#ly occur"
A+ter this ti$e, the #usiness $ay nee to o-erate !ith -ositive cash +lo! in
orer to survive"
Raising aitional ca-ital $ay not #e -ossi#le +ollo!ing a crash or a ra-i
slo!ing o+ activity !ithin an inustry"

5re-aring +or the transition to a s$aller sustaina#le #usiness $ay #e i++icult,
an $any co$-anies $ay close an #e li&uiate !hen a crash +inally
occurs"
=o!ever, #y -lanning a scenario +or the transition, !hile continuing to
survive the ra-i e3-ansion !ithout +alling #ehin co$-etitors, the #usiness
$ay #e a#le to continue o-erating on a long ter$ #asis"
623
5.19.5. Delining in(ustries
7eclining inustries $ay e3-erience +alling sales an -ro+its over a long
-erio o+ ti$e"
This $ay ty-ically occur !hen there is a +i3e unerlying e$an +or a
-rouct, an technology i$-rove$ents $ay ena#le the -rouct to #e
-rouce !ith +e!er an +e!er resources as ti$e goes #y"
2or e3a$-le, the trae o+ a co##ler, involving the $aking an re-airing o+
shoes, !as once a co$$on trae #ut is al$ost unkno!n in the $oern !orl"
As an inustry eclines ue to i$-rove technology, resources $ay #e
+ocuse in other irections an ne! inustries $ay e$erge"
A-erating in a eclining inustry $ay involve increasing volu$es in orer to
$aintain -ro+ita#le"
In cases !here ne! technology is #eing use, the #usiness $ay nee to kee-
u- to ate !ith the i$-le$entation o+ ne! technology, other!ise it $ay
graually loose sales an eventually #eco$e insolvent"
A sale to a co$-etitor an e3iting an inustry $ay #e one -ossi#le a--roach
in the case o+ a #usiness that o-erates in a eclining inustry"
/ost control $ay #e an i$-ortant issue in these cases, an $argins $ay #e
sli$ as -rices $ay nee to #e reuce in orer to slo! the ecline in sales
volu$es"
In these situations, $any #usinesses $ay #e availa#le +or sale, !ith lo!
-rices an little ti$e -ressure ue to the graually eclining nature o+ the
inustry"
5urchasing other #usinesses to e3-an si@e an reuce costs through
econo$ies o+ scale $ay #e an o-tion +or continue success+ul o-eration
!ithin the inustry"
#.0. 3ro:ect (evelopment
5ro9ect evelo-$ent involves -lanning, $anaging, an +uning a -ro9ect"
A -ro9ect is any activity that o-erates +or a +i3e -erio o+ ti$e an -rouces
a s-eci+ic result, rather than an activity that o-erates on a continuous #asis"
620
The Sno!y Mountains Sche$e is an e3a$-le o+ a large engineering -ro9ect"
This sche$e !as one o+ the largest civil engineering -ro9ects o+ the $oern
age"
This -ro9ect involve reirecting !ater +ro$ the Sno!y Mountains to irrigate
the +ar$ing -lains o+ 'ictoria an 4e! South Dales
The -ro9ect involve #uiling o@ens o+ a$s, hunres o+ kilo$etres o+
-i-eline, e$-loye thousans o+ !orkers an took over ten years to co$-lete
(>>check etails)"
5.2".1. T$pes of pro%et
5ro9ects $ay occur !ithin #usiness o-erations in a nu$#er o+ circu$stances"
5ro9ects $ay #e use to evelo- ne! -roucts an #uil ne! +acilities"
The evelo-$ent o+ large ite$s such as co$$ercial #uilings, $ines,
co$-uter so+t!are an +il$ -rouction $ay #e organise on a -ro9ect #asis"
5ro9ects $ay #e internal to the #usiness, or they $ay #e evelo-e +or clients
or +or later sale"
5.2".2. 3ro%et proposals
In so$e cases, the re&uire$ents +or a -ro9ect $ay #e clearly s-eci+ie"
In this situation, the -ro9ect $ay -rocee through the stages o+ esign an
construction"
In the case o+ teners +or a -ro9ect evelo-$ent, a #asic -ro9ect esign an
set o+ costs an ti$e +ra$es $ay #e esti$ate in orer to -re-are a tener +or
su#$ission to a -otential client"
In other situations, a -ro9ect $ay #e #ase on a general re&uire$ent or a set
o+ #roa ieas"
62*
In these situations, #asic esigns, sa$-le -roucts, scale $oels an
-rototy-e syste$s or ite$s $ay #e create to ena#le a +ir$ esign to #e
evelo-e"
5.2".3. -anaging t.e pro%et
Managing a -ro9ect $ay involve so$e o+ the +ollo!ing issues"
/o<orinating the various activities to ensure that the -ro9ect is
co$-lete accoring to the scheule ti$e +ra$es"
%nsuring that the -ro9ect is co$-lete !ith costs #eing in line !ith
the -ro9ect -lan"
%nsuring that the +inishe -rouct $atches the -rouct that !as
orere or esigne"
5.2".3.1.Development of a pro%et plan
The +irst task in the evelo-$ent o+ a -ro9ect $ay involve e+ining the
re&uire$ents an s-eci+ication o+ the ite$ to #e evelo-e"
In so$e situations a s-eci+ication $ay #e -rovie #y a client"
In other situations, such as internal -ro9ects, the -ro9ect $ay #e #ase on
so$e very general ieas an irections"
In the case o+ a clear an etaile s-eci+ication, the +irst stage $ay involve
evelo-ing a -ro9ect -lan, an esti$ating the $a9or tasks, $aterials, an ti$e
scheules that $ay #e involve in evelo-ing the ite$"
In the case o+ e3ternal clients, this $ay lea to the evelo-$ent o+ a tener or
a -ro9ect -ro-osal that $ay #e su#$itte to the client"
In the case o+ internal -ro9ects, the -ro9ect -lan $ay #e use to $ake a
ecision as to !hether to -rocee !ith the -ro9ect or not"
In large organisations this ecision $ay #e $ae #y the $anager res-onsi#le
+or the -articular area, or in the case o+ larger -ro9ects, #y a ca-ital
e3-eniture co$$ittee or the #oar o+ irectors"
62)
In the case o+ a s$all or iniviual enter-rise, the #usiness o!ner $ay $ake
the ecision as to !hether to -rocee !ith the -ro9ect or not"
This $ay also #e the -erson !ho -re-are the -ro9ect -lan, or the -ro9ect
-lan $ay #e -re-are #y another -arty, either internally to the co$-any or
e3ternally"
5.2".3.2.3ro%et plans
The -ro9ect -lan $ay inclue the costs an re&uire$ents +or the -ro9ect,
along !ith a etaile -ro9ect scheule"
A -ro9ect scheule $ay inclue a list o+ the tasks an ti$e +ra$es, the orer
that the tasks nee to #e co$-lete in, an the e-enences #et!een i++erent
-arts o+ the -ro9ect"
In $any cases, so$e -arts o+ a -ro9ect $ay not #e a#le to #e starte until
other sections o+ the -ro9ect have #een co$-lete"
In larger -ro9ects, $any se-arate activities $ay occur concurrently"
In these cases, an the e-enencies #et!een tasks $ay nee to #e $anage
to ensure that so$e tasks are not elaye +or long -erios ue to other
sections not #eing co$-lete"
In aition to -lanning the orer an ti$ing o+ the tasks, the $aterials neee
+or the -ro9ect $ay also #e s-eci+ie"
5.2".3.3.-anaging t.e pro%et
Managing the -ro9ect $ay involve asse$#ling tea$s o+ e$-loyees or
contractors, an assigning the various tasks to tea$s o+ iniviuals"
As the -ro9ect -rogresses, so$e tasks take a longer or shorter ti$e to
co$-lete than !as e3-ecte, an tasks $ay nee to #e re<scheule an
trans+erre #et!een tea$s in orer to ensure that evelo-$ent continues to
-rogress s$oothly"
628
In so$e cases, it $ay #eco$e clear $i<!ay through a -ro9ect that the
-ro9ect !ill not #e co$-lete #y the ue ate, or that signi+icant increases in
costs a#ove esti$ates !ill #e involve"
In these cases, this -ro#le$ shoul generally #e raise at the earliest -ossi#le
ti$e"
This $ay allo! alternative -lans to #e $ae in avance as re&uire, !ithout
the -ro#le$s a--earing at a ti$e that is close to the e3-ecte co$-letion
ate"
Also, $ulti-le e3tensions to a -ro9ect ealine $ay lea to a severe
eterioration in the relationshi- #et!een the #usiness an the client or other
-arties"
Dhen an alteration is $ae to a -ro9ect ealine or #uget, one alternative
$ay involve $aking a single large alteration on a single occasion"
Dhile this $ay not #e !ell receive, this $ay #e -re+erre to continual s$all
e3tensions to the co$-letion ate !ithout any clear en in sight"
=o!ever, i+ this ste- is taken, then the secon co$-letion ate $ay #eco$e
$uch $ore signi+icant, an a secon -ost-one$ent $ay -rove +atal +or +uture
orers +ro$ the client"
5.2".3.4.Design an( +onstrution
In so$e cases a -ro9ect $ay #e #roken into t!o $a9or stagesB esign an
construction"
This $ay a--ly in cases such as #uiling or constructing a s-eci+ic ite$,
rather than -ro9ects that involve a ne! evelo-$ent such as -rouct
evelo-$ent or research"
The esign stage $ay involve relatively +e! resources, #ut $ay involve a
consiera#le -erio o+ ti$e"
The ti$e -erio involve in esign $ay not #e signi+icantly reuce #y
allocating aitional resources to the -ro9ect"
In contrast, the ti$e involve in the construction -hase $ay #e irectly
relate to the resources allocate to the -ro9ect"
621
Allocating a large nu$#er o+ resources to a -ro9ect +or a short -erio o+ ti$e
$ay lea to several #ene+its"
Although this $ay not reuce the total !ork or costs involve in
construction, this a--roach $ay reuce the +i3e cost o+ the -ro9ect, such as
interest costs an the costs o+ te$-orary +acilities"
Also, this a--roach $ay reuce the risk o+ circu$stances changing or
o--ortunities #eing lost ue to a long ti$e elay in the co$-letion o+ the
-ro9ect"
A -reli$inary esign stage $ay nee to #e co$-lete in orer to -re-are the
#asic -ro9ect -lan, an to esti$ate the ti$e an cost involve in co$-leting
the -ro9ect"
A+ter the +ull esign is co$-lete, a etaile -ro9ect -lan o+ iniviual tasks
an $aterials $ay #e create, an +ull construction $ay #egin"
5.2".3.5.,e(uing (evelopment times
A nu$#er o+ #ene+its $ay arise +ro$ co$-leting a -ro9ect !ithin a short
-erio o+ ti$e"
The $ay involve so$e o+ the +ollo!ing -oints"
Reuce interest costs on e#t use to +un the -ro9ect e3-enses"
A reuction in the inco$e that $ay #e lost through not #eing a#le to
use the -ro9ect +acilities until the -ro9ect is co$-lete"
A reuction in the cost o+ arranging te$-orary +acilities, such as
te$-orary e&ui-$ent, or large<scale $anual -rocessing o+
a$inistration"
A reuce chance that changes in circu$stances $ay lea to the
-ro9ect +ailing to #e co$-lete, or no longer #eing relevant #y the
ti$e that it is +inally co$-lete"
A reuce chance o+ $issing o--ortunities that $ay only #e
availa#le +or a li$ite -erio o+ ti$e, such as activities relate to
s-eci+ic events, activities relate to +ashion or -o-ular -roucts
!ithin an inustry, an so on"
626
,arge -ro9ects $ay run +or several years, an in so$e cases the -revious
-oints $ay have a signi+icant i$-act on the #usiness"
A nu$#er o+ a--roaches $ay #e use to reuce the evelo-$ent ti$es +or a
-ro9ect"
This $ay inclue so$e o+ the +ollo!ing -oints"
5.2".3.5.1. 8arge resoure alloations
In so$e cases, -articularly uring the construction -hases o+ a -ro9ect, rather
than the esign -hases, allocating a large nu$#er o+ resources to a -ro9ect
$ay reuce the evelo-$ent ti$es"
This $ay involve using contract sta++, e3ternal service #usinesses, or using
internal e$-loyees or +acilities that $ay #e involve in other areas +or a
li$ite -erio o+ ti$e"
The -ossi#ility o+ using large resource allocations $ay also #e a -otential
#ene+it !ith the use o+ e3ternal services +or the evelo-$ent o+ large
-ro9ects, in situations !here a li$ite set o+ internal resources $ay lea to
long ti$e elays #eing involve in the evelo-$ent o+ large -ro9ects"
This -rocess $ay not alter the total a$ount o+ !ork that $ay #e involve in
co$-leting the -ro9ect"
=o!ever, reucing the -ro9ect evelo-$ent ti$e $ay reuce the total costs
o+ the -ro9ect through reuce interest costs, lease -ay$ents an so on"
5.2".3.5.2. 3arallel proesses
In so$e cases, several areas !ithin a -ro9ect $ay #e co$-lete concurrently,
rather than #eing co$-lete in a se&uence"
This -rocess $ay re&uire aitional resources, although this $ay also reuce
the -ro9ect evelo-$ent ti$e"
In contrast, co$-leting each -art o+ the -ro9ect in orer, one stage a+ter the
other, $ay lea to a long evelo-$ent ti$e"
630
Managing or evelo-ing a -ro9ect that involves $any -arallel -rocesses $ay
#e $ore i++icult that $anaging a se&uential -rocess"
A signi+icant a$ount o+ co<orination #et!een i++erent activities $ay #e
necessary to ensure that tasks are not co$$ence #e+ore other tasks that
$ust #e co$-lete +irst, an that tasks are not elaye !hile !aiting +or
other tasks to co$-lete"
5.2".3.5.3. -ultiple pro%ets
In so$e cases, elays at various -oints !ithin a -ro9ect $ay #e unavoia#le"
This $ay involve !aiting +or e3ternal su--lies, !aiting +or client revie!s,
!aiting +or stages to #e co$-lete #y e3ternal -arties, an so on"
In the case o+ o-erating several -ro9ects si$ultaneously, overla--ing the
-ro9ect !ork +ro$ each -ro9ect $ay allo! these ga-s to #e +ille !ith the
evelo-$ent o+ other -ro9ects"
This -rocess $ay result in the total ti$e that is re&uire to co$-lete all the
-ro9ects #eing reuce, in co$-arison to evelo-ing each -ro9ect in
se&uence"
5.2".4. Diretions vs. Development
So$e -ro9ects $ay #egin !ith a s-eci+ic research or evelo-$ent goal, an
$ay graually change to #eco$e a -er$anent -art o+ the #usiness o-eration"
These -ro9ects $ay -rove to #e a large rain on the cash +lo! o+ the #usiness"
Although in so$e cases a #usiness area such as this $ay regularly -rouce
use+ul s-eci+ic ite$s, such as co$-lete -rouct esigns, in other cases a
su#stantial o-eration $ay continue +or a long -erio o+ ti$e !ithout
-roucing anything that is o+ -ractical use to the #usiness"
This $ay involve evelo-$ents in various irections that change continually
over ti$e, !ithout -rogressing to the stage o+ co$-leting a s-eci+ic !orking
ite$"
631
This situation $ay -articularly occur in the case o+ an overly a$#itious
-ro9ect"
A -ro9ect such as this $ay egenerate into a -er$anent research -rocess that
oes not #ring any s-eci+ic ieas or -roucts to the stage o+ co$-letion"
The risk o+ -ro#le$s such as this arising $ay #e reuce #y initiating s$all
-ro9ects !ith s-eci+ic goals an ti$e+ra$es, rather than co$$encing large
an a$#itious -ro9ects that $ay never co$-lete"
5.2".5. 3ro%et /inaning
5.2".5.1./un(ing
2uning a -ro9ect $ay #e a $a9or issue in $any #usiness circu$stances"
In $any cases, inco$e $ay not #e receive +ro$ the results o+ a -ro9ect until
a+ter the -ro9ect has #een co$-lete"
,arge -ro9ects $ay run +or several years"
2uning a -ro9ect $ay #e one on a ca-ital or a cash +lo! #asis"
/a-ital +uning $ay involve raising a lu$- su$ o+ $oney at the #eginning
o+ the -ro9ect to -ay the -ro9ect e3-enses +or the uration o+ the -ro9ect"
This ca-ital $ay co$e +ro$ raising e#t, +ro$ raising e&uity +ro$ a -u#lic
share issue, +ro$ the general ca-ital o+ the #usiness, or +ro$ a custo$er !ho
arranges +or a -ro9ect ite$ to #e create"
/ash +lo! +uning o+ a -ro9ect $ay involve ra!ing cash +lo! +ro$ the other
o-erations o+ the #usiness, or +ro$ -rogress -ay$ents $ae #y a custo$er at
stages through the -ro9ect"
In other cases, the e3-enses o+ the -ro9ect $ay #e #ille irectly to a
custo$er, !ith the #usiness collecting a +ee +or the esign an $anage$ent
o+ the -ro9ect"
Interest on -ro9ect e#t $ay so$eti$es #e ca-italise uring the -ro9ect
evelo-$ent, in cases !here the inco$e +ro$ the -ro9ect $ay not #e
receive until a+ter the -ro9ect has #een co$-lete"
632
/a-italisation o+ interest $ay involve interest a$ounts #eing ae to the
current #alance o+ the e#t as the -ro9ect -rocees, rather than cash -ay$ents
o+ interest #eing $ae through the evelo-$ent -erio"
5.2".5.2.4nome
Inco$e +ro$ a co$-lete -ro9ect $ay +lo! in a nu$#er o+ !ays"
The co$-lete -ro9ect $ay #e sol at the en o+ the evelo-$ent -erio,
either to a custo$er that initially re&ueste the ite$, or as a general sale o+
the +inishe -rouct"
This situation $ay a--ly to the evelo-$ent o+ construction -ro9ects an
custo$ise so+t!are evelo-e +or a s-eci+ic client, +or e3a$-le"
Alternatively, the co$-lete -ro9ect $ay #e retaine #y the #usiness, an
use to generate a long ter$ inco$e strea$"
This $ay #e the case in -rouct evelo-$ent, +or e3a$-le"
5ay$ent +or a -ro9ect #y a client $ay #e $ae through instal$ents uring the
evelo-$ent -rocess, either at regular ti$es or as -articular $ilestones are
reache or stages are co$-lete"
5ay$ent can also occur as a lu$- su$ !hen the -ro9ect has #een co$-lete"
In so$e circu$stances, large -ay$ents $ay #eco$e ue, an the risk o+
e+ault on a -ay$ent $ay -resent a consiera#le risk to the #usiness"
2or e3a$-le, the #uiler o+ a co$$ercial o++ice #uiling $ay not !ish to
co$-lete the #uiling in case the client cannot -ay +or the #uiling at the en
o+ the -ro9ect"
=o!ever, the client $ay not !ish to -ay in avance, in case the #uiler oes
not co$-lete the #uiling"
A situation such as this $ay #e hanle using an escro! account"
An escro! account is hel in the na$e o+ a thir -arty, such as a co$$ercial
trustee"
In this e3a$-le, the client $ay e-osit the +uns in the escro! account, an
the #uiler $ay then co$$ence the construction"
633
Dhen the construction !as co$-lete, the +uns $ay #e release +ro$ the
escro! account to the #uiler"
%scro! accounts are so$eti$es use in large co$$ercial transactions"
5.2".5.3.-anaging as. flo5
Managing the cash +lo! o+ a -ro9ect $ay #e +airly straight+or!ar !hen the
-ro9ect is +inance #y a lu$- su$ that is raise at the #eginning o+ the
-ro9ect"
The initial ca-ital $ay #e -lace on e-osit, an +uns $ay #e ra!n o!n
to -ay e3-enses as the -ro9ect -rogresses"
In the case !here the -ro9ect is +une on a cash +lo! #asis, a scheule o+
e3-ecte inco$e an e3-ense a$ounts an the ates o+ each transaction $ay
#e -re-are"
2or e3a$-le, -ro9ect e3-enses $ay #e #ugete on a $onthly #asis, !hile
the client $ay $ake si3<$onthly -rogress -ay$ents"
A #u++er o+ ca-ital, or a e#t +acility such as an overra+t, $ay #e neee to
hanle situations !here the net ongoing #alance is negative, ue to an
e3-ense having to #e -ai #e+ore an inco$e a$ount is receive"
5.2".5.4./uture inome an( e)penses
In the case o+ short ter$ -ro9ects, the inco$e an e3-enses $ay #e si$-ly
ae an su#tracte to eter$ine the net inco$e or loss +ro$ the -ro9ect"
Dhen the e3-enses or inco$e +ro$ a -ro9ect $ay e3ten +or $ore than t!o
or three years, a i++erent a--roach that allo!s +or the ti$e value o+ $oney
$ay #e neee"
This issue is iscusse in etail in section #eginning on -age 820"
As an e3a$-le, the e3-enses +or the thir year o+ a -ro9ect $ay #e #ugete
to #e G10"
630
=o!ever, the initial ca-ital e-osit $ay earn interest over the three year
-erio"
This $eans that less than G10 $ay nee to #e set asie to $eet the -ay$ent
that !as ue in three yearCs ti$e"
An a$ount o+ G6, +or e3a$-le, $ay #e allocate at the start o+ the -ro9ect,
an $ay gro! !ith interest to e&ual the G10 -ay$ent that $ay #e ue in the
thir year"
This is the -rinci-le o+ the ti$e value o+ $oney, an a--lies to all
transactions that occur at i++erent -oints in ti$e"

A :-resent value; calculation $ay #e use to convert a +uture inco$e or
e3-ense a$ount to an e&uivalent value at an earlier ate"
The +ollo!ing +or$ula $ay #e use to calculate the -resent value o+ a +uture
cash +lo! that $ay occur in several yearCs ti$e"

years of number
rate erest int
amount
value present

,
_

100
1
2or e3a$-le, i+ the interest rate !as 10L, an a$ount o+ G20 in three years
ti$e coul #e converte to an e&uivalent a$ount on the current ate using the
+ollo!ing calculation
3
100
10
1
20

,
_

+
value present
03 1*. 5
In cases !here the -ro9ect +inancing calculations $ay e3ten over $ore than
t!o or three years, incluing either inco$e or e3-ense a$ounts, the -resent
value o+ each -ay$ent $ay #e use to eter$ine the total costs o+ the -ro9ect,
an the e3-ecte e++ective inco$e"
63*
2or e3a$-le, the +ollo!ing e3a$-le lists a scheule o+ costs over &uarterly
-erios +or a three year evelo-$ent -ro9ect, together !ith the total e++ective
cost o+ the -ro9ect"
4nterest ,ate 8<
;ear @uarter 'mount 3erio(s
3resent
:alue
1 1 1" "."" 1".""
1 2 1" ".25 9.81
1 3 1" ".5" 9.!2
1 4 1" ".75 9.44
2 1 1" 1."" 9.2!
2 2 1" 1.25 9."8
2 3 1" 1.5" 8.91
2 4 1" 1.75 8.74
3 1 1" 2."" 8.57
3 2 1" 2.25 8.41
3 3 1" 2.5" 8.25
3 4 1" 2.75 8."9
Total value of
osts 12"."" 1"8.19
In this e3a$-le, total e3-ense -ay$ents o+ G120 $ay #e $ae through the
course o+ the -ro9ect, ho!ever only G101 o+ ca-ital $ay nee to #e raise to
+un the -ro9ect"
5.2".5.5.3ro%et returns
In the case o+ long<ter$ inco$e an e3-ense calculations, several a--roaches
$ay #e use to eter$ine the net value o+ a -ro9ect"
An :internal rate o+ return; calculation $ay #e use to eter$ine a rate o+
return +ro$ a -ro9ect"
63)
This $etho $ay involve calculating the -resent value o+ all +uture inco$e
an e3-ense a$ounts, an eter$ining the interest rate that results in the total
o+ the -resent values #eing @ero"
This +igure $ay #e inter-rete as a rate o+ return +ro$ the -ro9ect"
This calculation $ay #e -er+or$e using a s-reasheet -rogra$, entering
esti$ate inco$e an e3-enses +or each +uture -erio, an using a goal<
seeking +unction to eter$ine the relevant iscount rate that sets the net
-resent value o+ all -ay$ents to @ero"
This iscount rate is kno!n as the internal rate o+ return o+ the cash +lo!s"
Although an internal rate o+ return calculation $ay -rouce a result that can
#e inter-rete as a -ercentage return +ro$ the -ro9ect, there $ay also #e
li$itations !ith this a--roach"
In cases !here the cash +lo!s $ay change sign at several stages through the
-ro9ect, changing +ro$ net in+lo!s to net out+lo!s, the IRR calculation $ay
-rouce several very i++erent results that are all $athe$atically correct"
Also, the IRR +igure $ay only re-resent an invest$ent return +or the +ull
ca-ital invest$ent !here early inco$e a$ounts coul #e re<investe at a
si$ilar rate to the internal rate o+ return"
Another a--roach $ay involve calculating a net<-resent<value +or the -ro9ect"
In this situation, a iscount rate $ay #e selecte #ase on the risk o+ the
-ro9ect, or #ase on a hurle rate that !as use !ithin an organisation +or
assessing -ro9ects"
The net -resent value that !as calculate using this a--roach $ay then
re-resent the ollar value o+ the -ro9ect"
In cases !here the net -resent value +igure !as -ositive, this $ay re-resent a
-ro9ect return that e3ceee the hurle rate o+ return"
(>> A--eni3 ?? contains an e3a$-le o+ a -ro9ect cash +lo! an return
analysis")
A net<-resent<value a--roach $ay also #e use to select -ricing +or teners
an -ro9ect -ro-osals"
638
In these situations, a stanar iscount rate coul #e use, an the net<
-resent<value o+ the -ro9ect coul #e use as the &uote -rice to co$-lete the
-ro9ect evelo-$ent"
This $etho $ay allo! a stanar -ricing a--roach to #e use +or a !ie
range o+ i++erent -ro9ects"
A net<-resent<value or internal<rate<o+<return calculation $ay only #e
a--lica#le in cases !here the inco$e that $ay #e generate +ro$ the -ro9ect
coul #e irectly esti$ate"
In the case o+ general -ro9ects, such as $arketing ca$-aigns or research into
ne! -rouct areas, the #ene+its o+ a -ro9ect $ay nee to #e assesse on the
#asis o+ the -ro9ectCs i$-act on the #usiness o-erations, rather than
esti$ating s-eci+ic +uture a$ounts"
5.2".5.!.#ummar$ of pro%et finaning alternatives
The +ollo!ing arrange$ents $ay inclue so$e -ossi#le alternatives +or the
+inancing o+ -ro9ect evelo-$ents"
+unding
/a-ital +uning
7e#t raising"
S-eci+ic e&uity ca-ital raising"
/a-ital source +ro$ the general ca-ital o+ the #usiness"
A sale o+ each -ro9ect stage as it is co$-lete to +un the
ne3t -ro9ect stage"
/ash +lo! +uning
/ash +lo! source +ro$ e3isting #usiness o-erations"
631
5rogress -ay$ents +ro$ clients, at +i3e intervals or as
-ro9ect stages are co$-lete or $ilestones are reache"
%3-enses #ille irectly to the client"
,ncome
/a-ital -ay$ents
,u$- su$ -ay$ent +ro$ the client an the #eginning or
en o+ the -ro9ect"
Sale o+ the co$-lete -ro9ect at the en o+ the -ro9ect"
/ash +lo!
5rogress -ay$ents +ro$ a client"
Inco$e +ro$ long<ter$ sales o+ a -rouct +ollo!ing the
co$-letion o+ the -ro9ect"
A long<ter$ inco$e strea$ o+ licence +ees +or licensing a
esign or technology evelo-$ent"
$eturns
Internal rate o+ return o+ the -ro9ect cash +lo!s"
4et -resent value using a risk<a9uste iscount rate to
eter$ine a ollar value +or a -ro9ect"
4et -resent value using a hurle rate o+ return, to eter$ine
!here a -ro9ect return e3cees the hurle rate"
636
#.1. 6anaging negative cash flo%
4egative cash +lo! occurs !hen the +uns that are +lo!ing out o+ the
#usiness in e3-ense an ca-ital -ay$ents are +lo!ing at a higher rate than the
in+lo! o+ cash +ro$ sales"
4egative case +lo! $ay occur ue to a te$-orary ro- in sales, uring the
evelo-$ent -hase o+ a -ro9ect, an in seasonal inustries"
A #usiness $ay nee to #e care+ully $anage uring a ti$e o+ negative cash
+lo!"
A -erio o+ negative cash +lo! $ay #e a regular -art o+ the #usiness activity"
=o!ever, negative cash +lo! $ay involve a steay ecline in the net assets
o+ the #usiness"
In this situation, the #usiness $ay o-erate !ith a +i3e -erio o+ ti$e until
insolvency occurs"
7uring a -erio o+ negative cash +lo!, the #usiness $ay nee to #e $anage
care+ully to ensure that the #usiness survives until cash +lo! #eco$es
-ositive, !ithout #eco$ing insolvent"
4egative cash +lo! $ay occur in so$e o+ the +ollo!ing circu$stancesE
5.21.1. +auses of negative as. flo5
5.21.1.1.3oor operating on(itions
4egative cash +lo! $ay occur !hen sales are lo! ue to lo! levels o+
econo$ic activity, or ue to issues such as -rouction -ro#le$s or ra-i
e3-ansion #y a co$-etitor"
In the case o+ te$-orary -ro#le$s, e3-enses $ay nee to #e -ost-one or
reuce in orer +or the #usiness to survive until -ositive cash +lo! is
restore"
In the case o+ -er$anent structural -ro#le$s !ith the #usiness, larger
changes $ay #e neee to change the #usiness into a sustaina#le o-eration,
such as iscontinuing large -ro9ects or loss<$aking o-erations an -roucts,
an investing in ne! -roucts or +acilities"
600
5.21.1.2.T.e (evelopment p.ase of a pro%et
7uring the evelo-$ent -hase o+ a -ro9ect, e3-enses $ay nee to #e -ai,
even through inco$e $ay not #e receive until a+ter the -ro9ect has #een
co$-lete"
In this situation, the #usiness $ay nee to ensure that it has su++icient
availa#le cash to co$-lete the -ro9ect"
In this is not the case, aitional cash $ay nee to #e raise through asset
sales or raising e#t or e&uity, the -ro9ect $ay #e iscontinue or sol to
another #usiness, or a 9oint venture !ith another #usiness $ay #e arrange to
co$-lete the -ro9ect"
5ro9ect $anage$ent $ay #e i$-ortant in this situation, to ensure that the
-ro9ect is co$-lete accoring to the -ro9ect scheule, an !ithin the cost
#uget"
5.21.1.3.,api( e)pansion
4egative cash +lo! $ay occur uring a -erio o+ ra-i e3-ansion"
In this situation, the costs o+ ne! +acilities an e3-ane o-erations $ay #e
larger than the inco$e +ro$ sales"
This $ay occur, +or e3a$-le, in the case o+ a success+ul -rouct or service,
or in the case o+ a ra-ily e3-aning inustry"
Ra-i e3-ansion $ay re&uire -erioically raising aitional e&uity ca-ital"
=o!ever, this -rocess $ay nee to #e care+ully $anage, as a #usiness $ay
#eco$e insolvent uring -erios o+ ra-i e3-ansion, ue to having
insu++icient cash reserves to $eet increase e3-ense levels"
5.21.1.4.#easonal in(ustries
In so$e inustries, sales $ay occur at -articular ti$es o+ the year"
601
2or e3a$-le, in so$e retail o-erations, hal+ the annual sales $ay occur
uring the $onth o+ 7ece$#er"
In the case o+ so$e agricultural -roucts, inco$e $ay occur once a year
+ollo!ing the harvest season"
5.21.1.5.+$lial in(ustries
So$e inustries $ay #e cyclical, an $ay have -erios o+ strong activity
+ollo!e #y long -erios o+ little activity"
The sale o+ consu$er ura#le ite$s, such as !hitegoos, $ay #e an e3a$-le
o+ this situation" (>> check etails)
In these cases, negative cash +lo! $ay occur uring -erios o+ lo! activity"
5.21.1.!.Development ativities
In so$e cases, a su$ o+ ca-ital $ay #e raise to -er+or$ a evelo-$ent
activity"
2or e3a$-le, in the $ining inustry, a su$ o+ ca-ital $ay #e raise to
conuct $ining e3-loration, an to atte$-t to locate an ore #oy an evelo-
a $ining o-eration"
In the case o+ a high gro!th inustry, e&uity ca-ital $ay #e raise to create a
ne! #usiness"
This ca-ital $ay #e use to evelo- ne! -roucts, an to atte$-t to evelo-
a sustaina#le client #ase or a sustaina#le level o+ sales"
In situations such as this, cash +lo! $ay #e negative +ro$ the $o$ent that
the e&uity +uns are raise, until a sustaina#le o-eration is create"
In so$e cases, several e&uity raisings $ay #e conucte until a sustaina#le
o-eration is evelo-e, or in other cases, the e&uity ca-ital $ay #e consu$e
!ithout esta#lishing a sustaina#le o-eration, an the #usiness activity $ay #e
issolve"
602
5.21.2. -anaging negative as. flo5
5.21.2.1.+as. levels
In the case o+ seasonal an cyclical #usiness, a level o+ cash $ay nee to #e
$aintaine in orer to -ay e3-enses uring -erios !here inco$e is not
su++icient to -ay e3-enses"
/ash levels $ay #e $aintaine +ro$ -revious net -ro+it, or aitional e&uity
+uns $ay #e raise in so$e circu$stances"
=o!ever, the o-tion o+ retaining cash or raising e&uity $ay only #e availa#le
#e+ore, rather than uring, the -erio o+ negative cash +lo!"
In this situation, -re-aration in avance $ay #e re&uire +or the #usiness to
#e a#le to -ass through a -erio o+ negative cash +lo! !ithout #eco$ing
insolvent"
This $ay -articularly a--ly in the case o+ une3-ecte negative cash +lo!,
such as negative cash +lo! cause #y a shar- ro- in the level o+ econo$ic
activity"
5.21.2.2.Time perio(s
In a situation o+ negative cash +lo!, a +i3e -erio o+ ti$e is availa#le until
the #usiness $ay #eco$e insolvent"
This ti$e -erio can #e calculate using the +ollo!ing +or$ula"
outflo( monthly net
value cash available
remaining months
2or e3a$-le, a #usiness $ay have inco$e o+ G10 -er $onth an e3-enses o+
G12 -er $onth, +or a net $onthly out+lo! o+ G2 -er $onth"
I+ the #usiness ha G21 o+ cash reserves, the -erio o+ ti$e until the #usiness
#eco$e insolvent coul #e calculate using the +ollo!ing e3a$-le"
603
2
21
remaining months
months 10
The ti$e -erio re$aining until insolvency $ay occur $ay #e e3tene #y
increasing cash levels through asset sales or e&uity raisings, reucing the rate
o+ out+lo!, or a co$#ination o+ #oth"
2or e3a$-le, i+ the rate o+ $onthly out+lo! !as reuce to G1"*0, an the
cash level !as increase to G3*, the ti$e -erio re$aining until insolvency
coul #e re<calculate using the +ollo!ing e3a$-le"
* 1
3*
.
remaining months
months 23
5.21.2.3.,e(uing negative as. flo5
A nu$#er o+ ste-s $ay #e taken that $ay reuce the $agnitue o+ negative
cash +lo! an the uration o+ a negative cash +lo! -erio"
This $ay inclue so$e o+ the +ollo!ing a--roaches"
Postponing e%penses
In cases o+ negative cash +lo!, $a9or e3-enses such as ca-ital -urchases o+
e&ui-$ent, -rouct evelo-$ent -ro9ects, an so on $ay #e -ost-one"
=o!ever, e3-enses o+ this ty-e $ay #e necessary in orer to ensure the long
ter$ survival o+ the #usiness"
In cases !here ca-ital e3-enses cannot #e +une +or an e3tene -erio o+
ti$e, alternative action $ay nee to #e taken"
600
2or e3a$-le, loss<$aking -roucts coul #e iscontinue, an aitional
e&uity or e#t coul #e raise to +un ca-ital -ro9ects an to evelo- a
sustaina#le #usiness o-eration"
$educing e%penses
Reucing e3-enses $ay #e one alternative +or reucing negative cash +lo!"
This $ay involve reucing sta++ nu$#ers, !here the ca-acity o+ the #usiness
is higher than the custo$er e$an +or -roucts or services"
In other cases, la#our<intensive -rocesses or out<ate e&ui-$ent $ay #e
re-lace !ith u-ate +acilities that allo! $ore e++icient o-eration an lo!er
costs<-er<unit"
=o!ever, changes o+ this ty-e $ay re&uire raising ca-ital to +un e&ui-$ent
-urchases an ne! evelo-$ents, an this $ay #e i++icult uring -erios o+
negative cash +lo!"
Reucing e3-enses $ay reuce #oth the si@e o+ the net cash out+lo! an the
uration o+ a negative cash +lo! -erio, ue to a s$aller rise in sales #eing
necessary to restore -ositive cash +lo!"
Reucing e3-enses $ay also have the #ene+it o+ reucing the rate o+ ecline
in the net assets o+ the #usiness, in contrast to other a--roaches such as asset
sales an changing inco$e structures, !hich $ay si$-ly restructure the
+inancial arrange$ents !ithout reucing the rate o+ asset ecline"
,ncome receipts
In so$e cases, negative cash +lo! -ro#le$s $ay #e reuce #y changing the
structure o+ inco$e that is receive"
2or e3a$-le, so$e o+ the +ollo!ing a--roaches coul #e use to erive
inco$e at earlier stages in a -ro9ect, an to s-rea inco$e cash +lo! into
several s$all -ay$ents, rather than occasional large -ay$ents"
5rogress -ay$ents at regular intervals through a -ro9ect, rather than
a lu$- su$ -ay$ent at the en o+ the -ro9ect"
7e-osits -ai #y custo$ers !hen orers are -lace +or -rouct
-urchases"
60*
5re<sales o+ -ro9ect evelo-$ents, !ith custo$ers -urchasing an
ite$ #e+ore construction is carrie out, an $aking -artial -ay$ents
than $ay #e use to $eet construction e3-enses
/o$-leting a -ro9ect in stages, !ith sales or -ay$ent occurring
a+ter each stage, rather than atte$-ting to +un the co$-lete
evelo-$ent o+ a large -ro9ect"
Reucing the length o+ creit ter$s o++ere to custo$ers"
The use o+ a +actoring service, or #ank #ills to ena#le +uns to #e
raise i$$eiately +ro$ custo$er accounts that $ay not #e ue +or
-ay$ent +or a -erio o+ ti$e"
5.21.2.4./i)e( an( variable osts
A #usiness that has a high -ro-ortion o+ +i3e costs $ay #e at greater risk o+
negative cash +lo! that a #usiness that has a high -ro-ortion o+ varia#le
costs"
2i3e costs $ust #e -ai regarless o+ the level o+ -rouction or sales, !hile
varia#le costs $ay ecline uring a -erio o+ lo! sales"
The -ro-ortion o+ varia#le costs $ay #e increase in so$e circu$stances #y
using so$e o+ the +ollo!ing a--roaches"
Hsing e3ternal rather than internal service areas, !here the volu$e
o+ services an -ay$ents can #e increase or ecrease to $atch
changes in sales levels"
Maintaining a co$#ination o+ -er$anent, te$-orary an contract
e$-loy$ent arrange$ents, in orer to ena#le sta++ levels to #e
e++ectively $anage uring -erios o+ high an lo! sales"
%nsuring that service an -rouct elivery is charge on a -er<
transaction #asis, rather than a +i3e ollar a$ount #asis"
Avoiing su--ly agree$ents that involve a re&uire$ent to acce-t
elivery o+ a +i3e or a $ini$u$ volu$e o+ -roucts on a regular
#asis"
60)
5.21.2.5.'lternative operations
In the case o+ seasonal an cyclical #usinesses, negative cash +lo! -ro#le$s
$ay #e reuce through the #usiness conucting t!o or $ore se-arate
#usiness activities"
This $ay not have a signi+icant e++ect on cash +lo! -atterns !hen the
activities are relate to the sa$e inustry or seasonal cycle"
=o!ever, in other cases this a--roach $ay have a signi+icant i$-act on the
length an severity o+ negative cash +lo! -erios"
2or e3a$-le, a retail outlet that sol !inter skiing e&ui-$ent $ay also sell
!aterskiing e&ui-$ent uring the su$$er $onths, to reuce -ro#le$s that
$ay arise ue to long -erios o+ ti$e -assing !ithout inco$e #eing receive
ue to seasonal e++ects"
In the case o+ a cyclical inustry such as #uiling construction, launching a
secon -rouct range or set o+ services that !ere not relate to the
construction inustry $ay reuce -ro#le$s that $ay arise uring -erios o+
lo! activity"
#.. Options
An o-tion is a situation in !hich a #usiness has a choice"
This $ay -articularly a--ly to contracts in !hich the #usiness $ay e3ercise a
choice"
2or e3a$-le, stanar o-tions contracts are trae on stock an +utures
e3changes"
These o-tions $ay allo! the #usiness to -urchase or sell a s-eci+ie &uantity
o+ a co$$oity, an a +i3e -rice, +or a s-eci+ie -erio o+ ti$e"
The o-tion holer $ay e3ercise the o-tion, in !hich case the s-eci+ie
transaction $ay go ahea, or allo! the o-tion to la-se, in !hich case no
transaction occurs"
A-tions $ay #e use !ithin co$$ercial -ro-erty leases, +or e3a$-le"
608
A -ro-erty lease $ay s-eci+y a ter$ o+ three years, !ith an o-tion to e3ten
the lease +or a +urther three years at the en o+ the +irst three<year -erio"
In contracts an other situations containing o-tions, the holer o+ the o-tion
$ay chose #et!een t!o or $ore alternatives"
The -arty granting the o-tion $ust acce-t the choice that is $ae #y the
o-tion holer"

A-tions $ay #e valua#le"
An o-tion $ay give the #usiness +le3i#ility, an $ay allo! it to aa-t to
changing circu$stances"
Also, an o-tion cannot have negative value"
In the #usiness conte3t, an o-tion $ay -rovie aitional alternatives an
$ay a +le3i#ility to the #usiness o-erations"
4ot all o-tions $ay #e use+ul, ho!ever aing o-tions cannot reuce the
value o+ a transaction or other #usiness situation
5.22.1. +ontrats
In the earlier e3a$-le, the lease !ith the three year ter$ an the three year
o-tion $ay #e $ore use+ul to the #usiness than either a +i3e three<year or a
+i3e si3<year lease"
In all three cases, the lease ter$ inclues the +irst three years"
=o!ever, !ith a three year lease, the #usiness $ay not have the alternative o+
re$aining in the -re$ises i+ the o!ner oes not o++er to rene! the lease"
In the case o+ a si3 year lease, the #usiness $ay not have the alternative o+
ening the occu-ancy at the en o+ the +irst three years"

Dith the o-tion lease, ho!ever, the #usiness $ay have the choice at the en
o+ the +irst three years to re$ain in the -ro-erty +or another three years, or to
$ove to alternative -re$ises"
A-tions $ay also #e use in contracts !ith custo$ers an su--liers"
601
2or e3a$-le, a custo$er su--ly agree$ent $ay inclue a $ini$u$ $onthly
elivery volu$e, !ith the o-tion +or the custo$er to select an increase
volu$e +or the $onth u- to a certain li$it"
In this case the #usiness is granting, rather than receiving, an o-tion"
This $ay #e costly to the #usiness in so$e cases, as the #usiness $ust #e
a#le to hanle orers +or either large or s$all volu$es, rather than +i3e
s$all or +i3e large volu$es"
This $ay re&uire $aintaining +acilities to su--ort large volu$es that $ay #e
unuse i+ the custo$er orer is s$all, or $aintaining +i3e +acilities +or s$all
volu$es that $ay re&uire aitional te$-orary +acilities i+ orers are large"
=o!ever, as this o-tion $ay #e valua#le to the custo$er, it $ay ena#le the
#usiness to $aintain higher average -rice levels, or coul #e use as a
$arketing su#siy to increase sales volu$es"
5.22.2. #tage( pro%ets
,arge evelo-$ent -ro9ects $ay so$eti$es #e #roken u- into several
ine-enent stages"
This -rocess $ay a value to a -ro9ect"
By #reaking a -ro9ect into stages, the nu$#er o+ -ossi#le +uture irections +or
the -ro9ect evelo-$ent $ay #e increase"
A stage -ro9ect evelo-$ent $ay allo! a ecision to #e $ae on a +uture
ate, !hen circu$stances $ay have change"
2or e3a$-le, a #usiness $ay #e una#le to +un the evelo-$ent o+ a large
-ro9ect !ithout receiving inco$e"
=o!ever, it $ay have su++icient +uns to co$-lete a single stage, sell the
co$-lete stage, an then use the inco$e +ro$ the sale to co$-lete the ne3t
stage"
Also, a consiera#le -erio o+ ti$e $ay -ass until a stage is co$-lete"
/ircu$stances $ay have change #y the ti$e that a stage is co$-lete, such
as a ro- in $arket -rices or custo$er interest, or an increase in ra!
$aterials -rices"
606
A stage -ro9ect $ay allo! +urther stages to #e -ost-one, or alternatively
the -ro9ect coul #e ene !ith the stages that ha alreay #een co$-lete"
In the case o+ a +ull evelo-$ent that re&uire all -arts o+ the -ro9ect to #e
co$-lete, losses $ay occur i+ ca-ital levels !ere insu++icient to co$-lete
the -ro9ect, or conitions change su#stantially over the course o+ the -ro9ect"
5.22.3. 8iste( options
A-tions $ay #e use in so$e +inancial $arkets instru$ents"
These contracts $ay #e trae in a si$ilar !ay to shares, an $ay #e kno!n
as e&uity o-tions, +i3e interest o-tions, +oreign e3change o-tions, or si$-ly
:o-tions;"
2or e3a$-le, a #usiness $ay su#$it a tener +or a evelo-$ent -ro9ect"
7evelo-ing the -ro9ect $ay re&uire a large e#t raising to -urchase ra!
$aterials +or construction"
=o!ever, interest rates $ay rise #e+ore the tener selection is $ae, an
#e+ore the #usiness can eter$ine !hether to arrange a e#t raising or not"

In so$e evelo-$ent situations involving large costs !ith sli$ $argins, a
s$all change in interest rates $ay have a large i$-act on the net -ro+it +ro$
a -ro9ect"
A situation such as this $ay #e hanle using a +i3e interest o-tion"
This $ay give the #usiness the a#ility to ra! o!n a loan on a +uture ate,
!ith the interest rate to #e set to the current interest rate rather than a +uture
interest rate"
As another e3a$-le, a +oreign e3change o-tion $ay give the #usiness the
o-tion to convert G10 o+ currency A to currency B, at the current e3change
rate o+ 0"83, at any ti$e !ithin the ne3t si3 $onths"
aluation
In so$e circu$stances, a value can #e calculate +or an o-tion"
6*0
The -ricing o+ o-tions is iscusse in the section #eginning on -age )63"
In cases !here o-tions a--ly to -rices, such as an o-tion that allo!s a certain
volu$e o+ a co$$oity to #e -urchase at a +i3e -rice, a value +or an o-tion
$ay #e calculate +ro$ the volatility o+ the $arket -rice o+ the unerlying
co$$oity"
In the case o+ -ro9ects an other situations, a $oel o+ the +inancial structure
o+ the situation coul #e evelo-e, an a co$-uter si$ulation a--roach
coul #e use to esti$ate a value +or an o-tion"
5.22.4. Fero*sum options
An o-tion $ay involve a irect +inancial trans+er +ro$ one -arty to the other
at the e3-iry o+ the o-tion"
2or e3a$-le, an o-tion that !as #ase on a volatile $arket -rice $ay result
in a trans+er +ro$ one -arty to the other at the co$-letion o+ the o-tion
-erio"
In this case, a +inancial #ene+it $ay not #e gaine or lost #y -urchasing or
granting an o-tion"
The -rice o+ an o-tion $ay #e #ase on the -ro#a#ility o+ a -ro+it occurring,
!ith the average -ro+it or loss +ro$ an o-tion transaction cancelling to @ero
over a large nu$#er o+ transactions"
=o!ever, o-tions such as these $ay #e use+ul in reucing the risk to the
#usiness o+ a large averse -rice change, an in $anaging cash +lo!"
In other situations, an o-tion $ay have a greater cost or #ene+it to one -arty
than the other"
Dhen this occurs, aitional value $ay #e create #y incluing o-tions
!ithin contracts"
2or e3a$-le, a cost $ay not #e involve in converting a large -ro9ect into a
stage -ro9ect, ho!ever aitional value $ay #e create through creating
o-tions !ithin the -ro9ect evelo-$ent"
As another e3a$-le, an o-tion !ithin a co$$ercial -ro-erty lease $ay have
$ore #ene+it to the #usiness than the cost to the #uiling o!ner"
6*1
2or e3a$-le, $oving -re$ises $ay #e a i++icult an e3-ensive -rocess +or
the #usiness, ho!ever changing tenants $ay have little a++ect on the #uiling
o!ner"
In situations such as these, creating o-tions $ay create value that $ay result
in an increase in sales volu$es or an increase in sustaina#le -rice levels"
#.!. Business 3ractices
5.23.1. Diret 4nvestigation
Dhen a situation is unclear an +urther in+or$ation $ay #e neee, irectly
investigating the situation $ay the $ost accurate !ay o+ clari+ying the
situation in &uestion"
State$ents $ae #y other -arties $ay #e $isleaing"
In so$e cases this $ay #e intentional"
In other situations, $isleaing in+or$ation $ay occur ue to
$isunerstanings, in+or$ation that a--lies to a i++erent situation that the
situation #eing iscusse, or in+or$ation that !as once correct #ut no longer
a--lies"
In so$e cases accurate in+or$ation $ay #e su--lie"
=o!ever, relying on state$ents $ae #y other -arties $ay not lea to the
sa$e level o+ unerstaning, or the sa$e o--ortunity to +or$ a clear vie!, as
a situation in !hich the #usiness investigates the situation an locates the
in+or$ation -ersonally"
Hnerstanings o+ the #usiness o!ner the$selves $ay later turn out to have
#een incorrect"
=o!ever, it is only -ossi#le to $ove +or!ar !ith the #est in+or$ation that is
availa#le at any -articular -oint in ti$e"
7ecisions $ay nee to #e $ae at each -oint in ti$e #ase on the availa#le
in+or$ation, in the +ull kno!lege that in+or$ation that is #elieve to #e
accurate $ay later turn out to #e incorrect"
6*2
Sourcing in+or$ation irectly, rather than relying on state$ents $ae #y
other -arties, $ay avoi $any -ossi#le -ro#le$s !ith the o-eration an
evelo-$ent o+ a #usiness"
In e3tre$e cases, a closure an li&uiation o+ a #usiness $ay occur i+ a large
transaction is co$$ence, an the transaction cannot #e co$-lete ue a
situation is !hich actions !ere taken on the #asis o+ in+or$ation that !as
su--lie #y another -arty, !hen in +act the in+or$ation !as incorrect"
5.23.2. ,eliabilit$
Relia#ility $ay #e very i$-ortant in #usiness"
2or e3a$-le, a $achine cannot generally #e shi--e until every iniviual
-art has #een asse$#le"
In an e3tre$e e3a$-le, a $achine !ith a large ca-ital value $ay #e hel +or
$onths !ithout shi-$ent ue to the unavaila#ility o+ a -art costing only a
+e! ollars"
This $ay lea to aitional costs in interest -ay$ents, e+ault on elivery
ates +or custo$er orers, an a serious isru-tion to the #usiness o-eration"
%nsuring a relia#le su--ly o+ $aterials $ay #e a signi+icant issue in the
$anage$ent o+ a #usiness o-eration"
Although cost an &uality $ay #e i$-ortant issues, relia#ility o+ su--ly $ay
also #e an i$-ortant issue in selecting su--liers"
Breaks in -rouction or elivery ue to a lack o+ su--lies $ay reuce the
e++iciency an volu$e o+ -rouction o+ the #usiness o-eration"
Also, in su--lying -roucts to custo$ers, relia#le su--ly $ay #e an
i$-ortant issue"
%nsuring that -roucts are su--lie to custo$ers in the re&uire volu$es,
an on the s-eci+ie ates, $ay #e i$-ortant in success+ully o-erating the
#usiness an e3-aning sales levels"
6*3
5.23.3. 3rie 5ars an( loss*ma6ing sales
Price wars
5rice !ars or $ay occur !hen -rices are reuce to #elo! the cost o+
-rouction, resulting in a loss occurring on sales"
This situation $ay occur !hen a co$-etitor atte$-ts to increase $arket
share !ithin an inustry #y selling -roucts at #elo! the cost o+ -rouction
+or a -erio o+ ti$e"
In the case o+ a -rice !ar, a #usiness $ay nee to reuce -rices in orer to
-revent sales volu$es +ro$ +alling"
This $ay re&uire the care+ul $anage$ent o+ the #usiness, until the -rice !ar
has +inishe an -rices return to sustaina#le levels"
A-erating a #usiness uring this ti$e $ay re&uire -ost-oning e3-enses such
as e&ui-$ent -urchases an ne! evelo-$ent -ro9ects, an reucing costs
that are not essential to the #asic #usiness o-eration"
Also, +ocusing $arketing an evelo-$ent activities on ne! -roucts an
niche -roucts that are use +or s-eci+ic -ur-oses $ay #e use+ul in so$e
circu$stances, as these -roucts $ay not #e e3-ose to the sa$e reuction in
-rice levels as general -roucts that $ay #e sol to a #roa custo$er #ase"
Loss-making price levels
5rice levels that are #elo! -rouction costs $ay also occur in the case o+
consoliating inustries"
In this situation, an inustry $ay #e co$-ose o+ a large nu$#er o+ s$all
enter-rises"
Technology i$-rove$ents $ay allo! econo$ies o+ scale to #e use in the
-rouction o+ goos, or the elivery o+ services"
In this situation, the cost<-er<unit $ay +all as the volu$e o+ -rouction rises"
Businesses !ithin the inustry $ay lo!er -rices in an atte$-t to increase
sales volu$es, !hich $ay lea to lo!er costs -er unit"
6*0
In this situation, #usinesses that e3-an volu$es $ay enter a cycle o+ rising
volu$es an +alling costs, !hile other #usinesses $ay either #e -urchase, or
$ay loose sales an eventually close or !ithra! +ro$ the inustry"
Dhen a consoliation -hase occurs, -rices across an entire inustry $ay #e
reuce to #elo! the cost o+ -rouction +or an e3tene -erio o+ ti$e, as
each #usiness $ay atte$-t to e3-an volu$es an $aintain a sustaina#le
o-eration"
In the case o+ o-eration in a consoliating inustry, a nu$#er o+ alternatives
$ay #e -ossi#le to reuce the -ossi#le losses that $ay occur, an to ensure a
sustaina#le +uture +or the #usiness"
This $ay inclue so$e o+ the +ollo!ing ite$s"
Merging !ith another organisation to increase the si@e o+ the
#usiness o-eration"
5urchasing other #usinesses to increase the level o+ sales"
Raising ca-ital an investing in u-ate an high<ca-acity +acilities,
to ena#le costs an -rices to #e reuce in avance o+ -otential sales
increases"
7evelo-ing niche an s-ecialty -roucts, or launching a -rouct
range !ithin a se-arate inustry, !here the -roucts are not e3-ose
to the sa$e -rice -ressure as the $ain inustry -roucts"
5.23.4. 8oss*ma6ing transations
Business o-eration $ay #e a yna$ic activity, !ith circu$stances constantly
changing an une3-ecte situations arising"
In so$e cases, a situation $ay occur !hen a loss<$aking transaction $ay #e
necessary to avoi an even greater loss occurring"
2or e3a$-le, a s-ecialise ite$ o+ e&ui-$ent $ay #e -urchase to
$anu+acture ite$s +or a $a9or custo$er"
=o!ever, shortly a+ter the -urchase, the custo$erCs #usiness $ay #eco$e
insolvent an #e li&uiate"
6**
Dithout the inco$e +ro$ the custo$er, serious cash +lo! -ro#le$s $ay
arise"
It $ay #e -ossi#le to locate a ne! custo$er to su--ly using the e&ui-$ent,
ho!ever this $ay take a consiera#le -erio o+ ti$e"
The #usiness $ay then #e +ace !ith the alternative o+ oing nothing, !hich
$ay lea to insolvency an li&uiation, or selling the e&ui-$ent at a large
loss in orer to raise cash to continue o-eration until ne! sales coul #e
generate"
In this situation, a sale o+ the e&ui-$ent $ay #e necessary in orer to
continue o-eration"
In so$e cases, a #usiness o-erator $ay #e reluctant to take this ste-"
=o!ever, initiating a loss<$aking transaction $ay #e necessary at certain
ti$es to allo! the #usiness to continue $oving +or!ar, an to -revent larger
losses +ro$ occurring"
In +or$ing a #usiness ecision, the relevant issues +or consieration $ay
relate to +uture events, rather than -ast events"
2or e3a$-le, the relevant issues involve eciing !hether to retain or sell
an invest$ent $ay involve the +uture -otential -ro+it or loss +ro$ the current
value, rather that the -ro+it or loss that $ay have occurre ue to the original
-urchase -rice o+ the asset"
In so$e cases, initiating a loss<$aking transaction $ay allo! the #usiness to
continue o-erating, an $ay #e necessary to in orer to continue a
sustaina#le #usiness o-eration an evelo- the #usiness into the +uture"
#.". *e(un(ancy & Bac+ups
A !ie range o+ une3-ecte situations can occur in #usiness, ranging +ro$ a
+ire in a $anu+acturing +acility, to a $a9or su--lier ceasing to su--ly ue to
an e3ce-te li&uiation o+ the #usiness"
In orer to -revent -ro#le$s !ith lost -rouction, +ailing to $eet custo$er
orers an so on, various ste-s $ay #e taken in avance to reuce the i$-act
that events such as these $ay have i+ they occur"
6*)
5.24.1. T$pes of ba6up
5.24.1.1.,e(un(ant s$stems
A reunant syste$ $ay involve $aintaining several syste$s that -er+or$
the sa$e +unction"
In the event o+ a +ailure in one syste$, the re$aining syste$s $ay allo!
o-eration to continue"
In so$e cases a reunancy arrange$ent $ay allo! +ull o-eration to
continue, !hile in other cases -rouction or service elivery $ay continue at
a reuce level"
Reunancy $ay #e inclue in $anu+acturing +acilities, #y using several
s$all $achines in -lace o+ a single large $achine"
In so$e situations, an entire -rouction +acility $ay #e s-lit into several
se-arate +acilities, each o+ !hich $ay o-erate ine-enently"
/ross<links #et!een i++erent co$-onents o+ +acilities $ay allo! one -art o+
a +acility to service other sections o+ the -rouction +acility, in the event o+ an
e&ui-$ent +ailure"
This a--roach $ay also #e use through arranging su--lies +ro$ several
su--liers, an in atte$-ting to evelo- a !ie custo$er #ase, to reuce the
risk that a $a9or loss o+ sales $ay occur ue to iscontinue orers +ro$ a
$a9or custo$er"
5.24.1.2.Ba6up failities
Backu- +acilities $ay involve +acilities that are not use as -art o+ the usual
-rouction -rocess, an that are s-eci+ically intene +or use in the event o+ a
+ailure o+ a $ain syste$"
Backu- +acilities $ay inclue -o!er generation +acilities, co$-uter ata
storage, an ite$s o+ e&ui-$ent that $ay #e ke-t +or use in the case o+ an
e&ui-$ent +ailure"
6*8
5.24.2. #uppl$ agreements
Being reliant on a single su--lier +or an essential in-ut to the #usiness
o-eration $ay create a risk +or the #usiness"
This $ay -articularly a--ly in the case o+ a -rouct that !as not !iely
availa#le in the o-en $arket, such as a -rouct that !as -rouce s-eci+ically
+or the #usiness"
In these cases, alternative su--liers $ay #e use to reuce the risk to the
#usiness o+ an iniviual su--ler ceasing to eliver"
The #usiness $ay source $aterials +ro$ several su--liers on a regular #asis"
In this case, a #reak in elivery #y one su--lier $ay #e hanle #y increasing
the orer si@e +ro$ another su--lier"
In cases !here volu$e iscounts !ere a signi+icant issue, the #usiness $ay
source the #ulk o+ the su--lies +ro$ a single su--lier, !hile sourcing s$all
volu$es +ro$ alternative su--liers to $aintain a regular +lo! o+ su--lies"
5.24.3. 8ines of re(it
,ines o+ creit, such as overra+ts, $ay #e $aintaine to su--ort the cash
+lo! o+ the #usiness uring an une3-ecte -erio o+ negative cash +lo!"
These +acilities $ay also -rovie the +uns that $ay #e neee to arrange
te$-orary +acilities or re-lace e&ui-$ent at short notice"
Stan<#y availa#le creit $ay #e a valua#le +acility +or the #usiness to hol"
This $ay $ean the i++erence #et!een li&uiation an continue o-eration in
the event o+ a $a9or une3-ecte -ro#le$ occurring"
Also, it $ay not #e -ossi#le to arrange these +acilities !hen the -ro#le$ has
alreay occurre, an $aintaining these +acilities on a long ter$ #asis $ay
ensure that +uns $ay #e availa#le !hen they $ay #e une3-ectely re&uire"
6*1
5.24.4. Doumentation
/o$-uter so+t!are, o-erating -roceures, an general in+or$ation neee to
o-erate the #usiness $ay #e ocu$ente !herever -ossi#le"
In -ractice, a great eal o+ ti$e an e++ort $ay #e involve in ocu$enting
-roceures an other in+or$ation, an kee-ing this in+or$ation u-<to<ate"
,arge volu$es o+ in+or$ation $ay #e i$-ractical to revie!, an in $any
cases $ay never #e rea, e3ce-t -ossi#ly as a re+erence -oint +or s-eci+ic
issues"
=o!ever, a set o+ si$-le notes that outline the key in+or$ation involve in
the #usiness o-eration $ay -rove invalua#le in the case o+ une3-ecte events
occurring"
5.24.5. Emplo$ee ba6ups
5ro#le$s $ay occur !hen an e$-loyee !ho -er+or$s a s-eci+ic range o+
tasks !ithin the #usiness o-eration resigns suenly"
In so$e cases, a single iniviual $ay $aintain a syste$ or -rocess
-ersonally, !ith other iniviuals in the organisation having little kno!lege
o+ the etails o+ the activity"
In cases !here an e$-loyee resigns suenly, this $ay lea to i++iculty !ith
continue o-eration"

These -ro#le$s $ay #e resolve over a -erio o+ ti$e, ho!ever te$-orary
isru-tion to o-erations $ay occur"
The risk o+ this -ro#le$ arising $ay #e reuce #y ensuring that other
iniviuals are #roaly +a$iliar !ith the activities involve"
2or e3a$-le, this coul #e achieve #y having another e$-loyee -er+or$ the
role o+ a #ack u- +or the activity, an -er+or$ a s$all -ercentage o+ the
transactions to re$ain +a$iliar !ith the -roceures"
7ocu$enting -roceures $ay also #e use+ul in so$e cases, ho!ever this
$ay not su#stitute +or -ractical e3-erience in $aintaining a syste$ or
-rocess, or -er+or$ing a co$-le3 activity !ithin the #usiness o-eration"

6*6
A #acku- arrange$ent o+ this ty-e $ay #e use+ul then the -ri$ary -erson is
a#sent, such as on annual leave, or i+ they resign suenly"
5.24.!. +omputer e9uipment
Backu-s an reunant syste$s $ay #e heavily use in co$-uter syste$s"
Main+ra$e syste$s, +or e3a$-le, $ay have an entire +acility u-licate !ith
an ientical +acility as a #ack<u- to the $ain o-eration"
Backu-s o+ ata storage $ay #e regularly ke-t o+ co$-uter ata use !ithin
#usiness o-erations, !ith ata co-ie to ta-es or other re$ova#le $eia"
2or e3a$-le, this $ay involve nightly #acku-s o+ ata storage, !ith aily
co-ies o+ ata ke-t +or the last 30 ays, an !ith $onthly in+or$ation ke-t
+or a -revious nu$#er o+ years"
Backu- in+or$ation $ay #e trans-orte o++<site to avoi loss o+ the entire
syste$ in the event o+ a +ire"
/o$$ercial #uilings $ay inclue #acku- generators to su--ly -o!er in the
event o+ a co$$ercial -o!er +ailure, an co$-uter syste$s $ay so$eti$es
inclue si$ilar -o!er #acku- evices an u-licate e&ui-$ent"
=o!ever, #acku- e&ui-$ent an +acilities $ay #e e3-ensive, an in general
the #acku- +acilities use $ay nee to #e assesse in the light o+ the realistic
likely scenarios"
2or e3a$-le, !ith -o!er lost to an entire #uiling, -o!er #acku-s +or
iniviual co$-uters $ay #e o+ little use in -ractice"
5.24.7. E)essive re(un(an$ an( ba6ups
In so$e cases, consiera#le e3-ense $ay #e involve in creating #acku-
+acilities"
2or e3a$-le, creating a co$-lete #acku- +acility o+ a $ain +acility $ay result
in a ou#ling o+ the cost o+ creating the entire +acility"
In -ractical ter$s, the level an co$-le3ity o+ #acku- syste$s that are use
$ay nee to #e assesse in ter$s o+ the chance o+ the +acility #eing re&uire,
6)0
the i$-act on the #usiness i+ a +ailure occurre, the likely +re&uency o+
+ailures, an the -ractical i++iculty in aressing a -ro#le$ i+ it actually
occurre"
2or e3a$-le, although #acku- -o!er generation +acilities $ay #e -rovie in
so$e co$$ercial #uilings, in -ractice the co$$ercial -o!er su--ly $ay
+ail on rare occasions an generally +or short -erios o+ ti$e"
5.24.8. Eeeping ba6ups operational
Backu- syste$s, !hether they are o-erational, +inancial or co$-uter relate,
$ay nee to #e $aintaine an use regularly in orer to re$ain o-erational"
2or e3a$-le, sourcing a s$all regular volu$e o+ goos +ro$ a #acku-
su--lier $ay ensure that the etails o+ the #usiness accounts, elivery etails,
settle$ent o+ invoices an other issues !ere continuing to o-erate s$oothly,
an that the su--ly $ay #e availa#le in the event that the $ain su--lier
cease to eliver su--lies"
Backu- +inancial arrange$ents, such as lines o+ creit, $ay nee to #e
regularly checke to ensure that they are still availa#le"
In the case o+ e&ui-$ent an co$-uter ata #acku-s, these +acilities $ay
nee to #e use on a regular #asis to ensure that they re$ain o-erational, an
that they $ay #e availa#le as they are neee"
#.#. Negotiation
4egotiation #et!een the #usiness an other -arties $ay occur in a !ie
range o+ situations"
This $ay inclue negotiations !ith custo$ers an su--liers, involving
-rices, volu$es, an elivery conitions"
4egotiation $ay also #e involve in the -rocess o+ -urchasing or selling a
large asset such as a $anu+acturing +acility or a #usiness"
4egotiation situations $ay arise in $any circu$stances, ranging +ro$
iscussions !ith govern$ent authorities involving i$-orting an e3-orting
licenses, to iscussions involving the +ailure o+ a $a9or 9oint venture -ro9ect
!ith another #usiness"
6)1
5.25.1. =egotiation situations
4egotiations situations $ay +all into t!o categories"
This $ay inclue negotiations that are conucte as -art o+ a transaction,
such as a negotiation !ith a $a9or custo$er"
2or e3a$-le, a #usiness that su--lies a co$$oity on a regular #asis, such as
a $ining o-eration, $ay #e involve in e3tene negotiations !ith a
-otential custo$er regaring -rices, volu$es, -ay$ent ter$s, an other
etails o+ a su--ly agree$ent"
Also, negotiations $ay occur in e+ence to atte$-ts to !ithra! value +ro$
the #usiness, such as atte$-ts #y custo$ers to secure reuctions in -rices,
an negotiations in situations involving threats o+ legal action #eing taken
against the #usiness"
5.25.2. =egotiation preparation
%++ective negotiation $ay re&uire etaile in+or$ation"
This $ay inclues a +ull unerstaning o+ so$e o+ the +ollo!ing issuesE
A -rouctCs strengths an !eaknesses
The co$-lete #ackgroun to a situation, incluing an accurate
kno!lege o+ the events that actually occurre"
The #usinessCs o-erational an +inancial structure, so that the
i$-act o+ altering volu$es an so +orth coul #e consiere"
An unerstaning o+ the custo$erCs -ers-ective, an -articular
issues that $ay a++ect a custo$er or su--lier in a -articular
situation"

A consieration o+ the various things that coul #e o++ere
uring a negotiation -rocess, such as #reak<even -ricing levels,
the relationshi- #et!een -rices that !ere &uote an eventual
-ro+ita#ility, an alternative ite$s such as -re<-ay$ent that
6)2
$ay #e #ene+icial to the custo$er an coul #e o++ere uring a
negotiation -rocess"
Also, so$e thought $ay #e given to the general situation, an the nature o+
the iscussions"
This $ay reuce the chance o+ agreeing to an arrange$ent that $ay later #e
regrette, an the chance o+ +alling #ack against sustaine -ressure +ro$ the
other -arty"
5.25.3. =egotiation proesses
4egotiation $ay #e $ost e++ectively hanle through irect an clear o++ers"
The other -arty $ay then res-on in various !ays, incluing -ro-osing a
counter o++er"
This -rocess $ay continue +or so$e ti$e"
=o!ever, an e++ective negotiation $ay re&uire that the #usiness +ocus clearly
on its o!n -osition, an choose care+ully as to !hen to acce-t a i++erent
-ro-osal, !hen to suggest a i++erent arrange$ent, !hen to stan +ir$ an
ecline to alter an o++er that currently stans, an !hen to !ithra! +ro$
negotiations"
%ach a--roach to negotiation $ay #e i++erent, ho!ever so$e general
-rinci-les $ay a--ly"
.ithdrawing from a negotiation
A ecision to !ithra! +ro$ a negotiation shoul #e $ae care+ully, an
once the ecision has #een taken , it shoul not generally #e reverse"
Threatening to !ithra!, or !ithra!ing on a !hi$ an then re<entering a
negotiation, !ill estroy the #usinessCs a#ility to $aintain a clear -osition
that leas to either acce-tance or re9ection +ro$ the other -arty"
+i%ed offers
6)3
Ane -ricing alternative $ay involve $aking an early ecision regaring a
$ini$u$ -rice level, an then o++ering this -rice as a +i3e o++er"
This a--roach $ay have the #ene+it o+ saving a consiera#le -erio o+ ti$e"
In a serious #usiness negotiation, this -osition $ay generally #e acce-te at
+ace value, an the other -arty $ay either acce-t or re9ect the o++er as it
stans"
2i3e -ricing $ay #e use in retail an service #usinesses, an $ay also #e
use +or asset sales"
Development of contracts
In so$e cases, negotiation $ay involve general iscussions, +ollo!e #y a
series o+ revisions to a ra+t agree$ent"
2or e3a$-le, the evelo-$ent o+ co$-le3 +inancing an -ro9ect
arrange$ents $ay #egin !ith general iscussions involving the #asic
structure o+ a transaction"
This $ay #e +ollo!e #y one -arty -roucing a ra+t set o+ contract
conitions"
The other -arty $ay then $ake a large nu$#er o+ s$all changes, an return
the contract +or +urther consieration"
This -rocess $ay continue, !ith the contract -assing through a nu$#er o+
revisions, until the current agree$ent $ay #e acce-te as it stans"
Counter offers
In other cases, o++ers an counter o++ers $ay #e use to eter$ine the
co$#ination o+ -rices, volu$es, an other conitions that $ay #e inclue in
a su--ly agree$ent"
This situation $ay -articularly a--ly in the case o+ large transactions such as
-urchasing a #usiness, an in cases !here the issues that $ay #e i$-ortant to
the other -arty $ay not #e clear"
This -rocess $ay allo! the #usiness to evelo- an o++er that $ay #e
attractive to the custo$er, !hile avoiing incluing +eatures that $ay #e
costly to the #usiness, #ut $ay #e o+ little #ene+it to the custo$er"
6)0

This -rocess $ay continue, !ith the o++ers an counter o++ers converging
to!ars an agree$ent, until either a -arty !ithra!s +ro$ the negotiation, or
a -arty acce-ts an outstaning o++er as it stans"
An acce-tance $ay take the +or$ o+ a irect acce-tance, or a -ro-osal to
accent the current o++er, su#9ect to so$e $inor changes"
Technically, this secon a--roach $ay #e consiere to #e a counter o++er,
ho!ever this ste- $ay inicate that a ecision has #een $ae to -rocee !ith
the transaction as it stans, an that the changes that $ay #e suggeste $ay
#e $inor"
In so$e cases, as ti$e -asses it $ay #eco$e clear that an agree$ent !ill not
#e reache, an the #usiness $ay !ithra! +ro$ the negotiation"
5.25.4. 4(entifie( ranges
In so$e cases, a negotiation $ay continue +or an e3tene -erio o+ ti$e
#e+ore it #eco$es clear that an agree$ent !ill not #e reache"
To reuce the risk that this situation $ay arise, a set o+ negotiation ranges
$ay #e use
This situation $ay -articularly a--ly to cases !here the negotiation relates
-ri$arily to -rice, rather than to a range o+ aitional issues"
Hner this a--roach, #oth the #uyer an the seller $ay in+or$ a thir -arty o+
their negotiation ranges"
The thir -arty $ay then announce that there is no overla- in ranges, an that
agree$ent is not -ossi#le"
Alternatively, an announce$ent $ay #e $ae that an overla- in the ranges
e3ists, an a stanar negotiation -rocess $ay #egin"
This $etho !as so$eti$es use in the ancient !orl"
5.25.5. =egotiation tatis
A !ie range o+ negotiation tactics $ay #e use #y o--osing -arties"
6)*
Discussion & criticism
Ane $a9or a--roach $ay involve iscussing an criticising the ite$ +or sale"
The #usiness shoul re+use to iscuss these issues at all costs"
Asie +ro$ ans!ering &uestions o+ +act, an res-oning to o++ers, no
iscussion shoul #e entere into regaring the o#9ect itsel+"
In taking this ste-, the o--osing -arty $ay atte$-t to isconnect the
#usinesses +ro$ the a#ility to $aintain a clear o++er"
In a++ect, the o--osing -arty $ay atte$-t to esta#lish a situation in !hich the
#usiness oes not o!n the ite$, an is not +ree to $ake or re9ect o++ers as it
sees +it"
In res-oning to state$ents an #eco$ing ra!n into a iscussion involving
the ite$ itsel+, the #usiness $ay loose the a#ility to clearly choose its o!n
-osition, an $ay #eco$e o-en to $ani-ulation #y the other -arty"
Dela*
7elay $ay #e use as a negotiation tactic"
This $ay -articularly a--ly in the case that the custo$er has ongoing
o-erations an $ay not nee the ite$ !ithin a short -erio, !hile the
#usiness $ay nee a transaction to #e $ae !ithin a short ti$e +ra$e in
orer to $eet -ay$ents that $ay soon #e ue"
7elay is a -ossi#le ha@ar o+ negotiation"
The #usiness $ay nee to res-on to this #y acce-ting the loss that $ay arise
+ro$ a elay as a cost o+ negotiation, an $aintain current levels !ithout
allo!ing -rices or o++ers to reuce as ti$e -rogresses"
The elay itsel+ $ay #e costly"
This $ay involve costs such as interest, losses !here e3-enses continue
ho!ever -rouction or service elivery oes not occur, an the cost in
-ersonal resources o+ the negotiation -rocess"

6))
This situation $ay -articularly a--ly !hen a negotiation is -ost-one several
ti$es #e+ore a situation is +inally resolve"
7elay $ay nee to #e irectly consiere as a signi+icant issue in the
negotiation -rocess"
The #usiness shoul not generally agree to a elay lightly, an $ay take
su#stantial ste-s to ensure that short ti$e -erios occur #et!een stages in the
-rocess"
A -ost-one$ent shoul never #e acce-te !ithout setting a +ir$ ate to
continue iscussions"

In the case o+ a -ost-one$ent !ith a ate to #e eter$ine at a +uture ti$e,
the #usiness shoul either gain agree$ent +or a +i3e ate, or consier that
this ste- results in the ter$ination o+ the negotiation -rocess, an shoul
!ithra! +ro$ the -rocess"
Dhen this is not -ossi#le, all -ractical ste-s shoul #e taken to ensure that a
+ir$ ate is agree, an that the ti$e elay is as short as is -ractical"
(motional manipulation
%$otional $ani-ulation $ay #e use in negotiation situations"
This $ay involve a range o+ iscussions ai$e at !eakening the a#ility o+ the
#usiness to +or$ a clear an ine-enent ecision regaring its o!n actions"
These iscussions $ay involve co$$ents regaring the ite$ itsel+,
co$$ents irecte at the -erson conucting the negotiation, co$$ents a#out
general issues, an atte$-ts to create $ental ieas an i$ages !ithin the
$in o+ the -erson conucting the negotiation"
2or e3a$-le, a range o+ su#tle criticis$s o+ the #usiness or the -rouct $ay
#e $ae, !ithin the conte3t o+ +rienly co$$ents that $ay #e intene to
o-en the #usiness to actions that $ay reuce the a#ility o+ the #usiness to
$aintain a clear -osition !ithin the negotiation"
The -ri$ary e+ence against these actions $ay involve eclining to engage in
general iscussions"
The #usiness shoul restrain itsel+ to si$-ly $aking o++ers, res-oning to
o++ers +ro$ the other -arty, an asking or ans!ering &uestions to clari+y +acts
regaring the ite$"
6)8
,nformation concerning the "usiness
Dhere -ossi#le, the #usiness shoul avoi revealing in+or$ation a#out itsel+,
as this $ay allo! the o--osing -arty to take an action that $ay result in an
un+avoura#le outco$e +or the #usiness"
Ance in+or$ation has #eco$e availa#le, it cannot #e !ithra!n"
In this situation there $ay #e no action that the #usiness $ay take to reverse
the -ro#le$ an esta#lish an outco$e on $ore +avoura#le ter$s"
2or e3a$-le, the #usiness $ay have cash +lo! -ro#le$s, an #e in urgent
nee o+ a transaction to $eet u-co$ing -ay$ents"
Kno!ing this, the o--osing -arty $ay loge a lo! o++er an re+use to alter
the o++er, kno!ing that the #usiness $ay have no alternative #ut to acce-t the
lo!er o++er"
Dithout this kno!lege, a -rice that !as negotiate $ay #e closer to the
natural -rice level o+ the -rouct"

As another e3a$-le, the #usiness $ay hol an e3cess stock-ile o+ a -articular
su--ly, !ith a nee to clear storage s-ace"
In o++ering the ite$ +or sale, a stanar -rice coul #e negotiate"
=o!ever, i+ the custo$er !as a!are o+ the -ro#le$, they coul loge a +ir$
+i3e o++er at a lo! -rice, kno!ing that transaction $ay not +ail as !oul
nor$ally #e e3-ecte, #ut that the #usiness $ay #e +orce to acce-t the lo!er
ter$s"
5.25.!. '((itional items
5rice, &uality, volu$e o+ su--ly an relia#ility o+ su--ly $ay all #e $a9or
issues in a #usiness negotiation"
=o!ever, in so$e cases a range o+ other #ene+its $ay #e o++ere to a
custo$er or su--lier as -art o+ a negotiate agree$ent"
This $ay inclue so$e o+ the +ollo!ing ite$s"
6)1
5re<-ay$ents, -rogress -ay$ents, an -ay$ents in avance"

The #usiness assu$ing certain risks +ro$ the custo$er, such as
su--lying a co$$oity at a +i3e -rice even though the $arket
-rice $ay #e volatile"
%scro! arrange$ents an -rogress -ay$ents to reuce the clientCs
risks o+ e+ault on -ay$ents #y the #usiness"
'aria#le volu$e arrange$ents, !ith the custo$er #eing a#le to vary
volu$e re&uire$ents !ithin ranges"
An<going service an su--ort agree$ents, such as s-eci+ie
res-onse ti$es to $aintenance -ro#le$s"
Stan<#y arrange$ents to re-lace e&ui-$ent !ith alternative
su--lies at short notice, to continue -rouction in the event o+
e&ui-$ent +ailure"
5ay$ent ter$s !ith the custo$er #eing a#le to $ake -ay$ents in
instal$ents over a -erio o+ ti$e"
Incluing other -roucts an services !ithin a su--ly agree$ent,
either +ro$ the #usiness itsel+ or +ro$ other -arties"
Arrange$ents !here the custo$er or istri#utor oes not nee to
-urchase the goos +ro$ the #usiness, an so oes not nee to
source +uning, eal !ith creit risk, or #ear the risk o+ holing
unsol ite$s" This $ay inclue arrange$ents such as a sale<or<
return arrange$ent, -ercentage istri#ution +ees, e3-enses #ille
irectly to the #usiness an so on"
5.25.7. Base 3ositions
In a negotiation situation, thought $ay #e given to the #ase case at !hich the
negotiation coul not -rocee +urther, an the #usiness !oul !ithra! +ro$
the negotiation"
It $ay #e i$-ortant to think this -rocess through clearly #e+ore the
negotiation -rocess #egins"
6)6
Ance the negotiation -rocess #egins, all e++orts $ay #e necessary to resist
-ressure +ro$ an o--osing -arty"
It $ay not #e -ossi#le to $ake +urther -rogress on consiering issues, an the
#usiness $ay nee to negotiate +ro$ the #asis that has #een #uilt through the
initial -erio o+ consiering the situation"
In so$e cases, a clear $ini$u$ -rice or other ecision $ay #e $ae in
avance"
In other cases, this $ay not #e -ractical"
=o!ever, s-ening ti$e consiering the issues an the situation #e+ore the
negotiation co$$ences $ay #e use+ul in clari+ying thoughts in -re-aration
+or the negotiation activity"
5.25.8. 7ne)pete( events
In cases !here an une3-ecte event occurs, such as a state$ent +ro$ the
o--osing -arty that !as not conte$-late #y the #usiness, a short #reak $ay
#e re&ueste to consier the issue"
This $ay range +ro$ a short -ause to a -ost-one$ent +or a -erio o+ ays or
even !eeks"
%very e++ort shoul generally #e $ae to avoi $aking a state$ent until ti$e
has -asse to allo! the une3-ecte state$ent to #e thought through"
Ans!ering i$$eiately or thinking alou $ay involve revealing in+or$ation
that the #usiness i not !ish to reveal"
Also, !hen agree$ent to a ne! conition has #een $ae or suggeste, this
$ay not easily #e !ithra!n
Although the #usiness $ay !ithra! a conition that !as -reviously o++ere,
in -ractice this action $ay #e costly in a negotiation situation"
%ach ter$ that is agree $ay #eco$e the ne! #ase -osition +or +urther
negotiation, an conceing a ter$ or conition #e+ore the issues have #een
care+ully consiere $ay result in a loss o+ value in a negotiate agree$ent"
Also, an une3-ecte event $ay alter the yna$ics o+ the negotiation
situation"
680
In the case o+ the #usinesses res-oning !ithout having thought through the
issues, this action $ay lea to the other -arty taking control o+ the
negotiation"
In this case, the a#ility o+ the #usiness to $aintain a -revious -osition, or to
resist -ressure +ro$ the o--osing -arty $ay #e a$age"
2or e3a$-le, the o--osing -arty $ay suggest that a large ite$ o+ e&ui-$ent
#e -urchase in stages, !ith each aitional stage #eing o-tional +or the
custo$er"
The #usiness $ay not have conte$-late this -ossi#ility"
In res-oning that this $ay #e -ossi#le, !ithout thinking the issue through
+irst, the #usiness $ay e++ectively concee this -oint, an this $ay #eco$e
the ne! #ase line +or negotiation"
This action $ay have several i$-lications"
The #usiness $ay e++ectively #eco$e locke into the arrange$ent, an $ay
have i++icultly in !ithra!ing +ro$ this #asis an returning the negotiation
to a -revious -oint"
Also, having concee this -oint, the #usiness $ay loose the a#ility to o++er
this issue as a ne! #ene+it in a +uture o++er"
5oints that have #een concee $ay #e reverse at +uture ti$es #y si$-ly
announcing that a ecision has #een $ae to !ithra! this -articular -oint
+ro$ the range o+ issues o++ere, ho!ever this $ay #e costly"
4egotiations $ay -rocee +or!ar in $any irections, ho!ever they cannot
#e reset to an earlier stage"
/onceing -oints or o++ering in+or$ation !ithout care+ully consiering the
i$-lications $ay -er$anently reuce the value that a #usiness $ay #e a#le
to e+en in a negotiation situation"
5.25.9. Bea6 bargaining positions
In so$e negotiation situations, the #usiness $ay +in itsel+ to #e in a !eaker
#argaining -osition than the o--osing -arty"
681
This situation $ay arise in so$e o+ the +ollo!ing circu$stances"
Dhen several su--liers are availa#le as alternatives to the #usiness,
ho!ever only one or t!o $a9or custo$ers e3ist !ithin an inustry"
Dhere only one or a s$all nu$#er o+ su--liers e3ist, ho!ever the
su--lier $ay have $any other custo$ers in aition to the #usiness"
Then a su--lier su--lies an essential in-ut to the #usiness
-rouction or -rocess that cannot #e reaily source +ro$ other
su--liers"
Dhen the #usiness $ay #e e3-eriencing cash +lo! or other
-ro#le$s, !hich $ay create ti$e urgency, ho!ever the o--osing
-arty $ay not have ti$e urgency"
2or e3a$-le, the #usiness $ay o-erate in an inustry that $ay inclue
several alternative su--liers, #ut only one or t!o $a9or custo$ers"
In this case, the custo$er $ay !ithra! +ro$ a negotiation at any ti$e !ith
little loss, an $ay source su--lies +ro$ an alternative su--lier"
In contrast, the #usinessCs entire sales $ay #e e-enant on a single
custo$er, an the #usiness $ay #e una#le to continue o-erating !ithout sales
to the custo$er"
In the case o+ !eak #argaining -ositions, one -ossi#le negotiation a--roach
$ay involve the +ollo! ste-s
7eter$ining a #ase -osition or -ricing level that $ay re-resent a
$ini$u$ level +or the #usiness o-eration"
A++ering the #ase -osition as a irect +i3e o++er"
7eclining to agree to reuctions #elo! the #ase -ricing level or
other #ase conitions"
In this arrange$ent, the other -arty $ay either acce-t or re9ect the -ro-ose
o++er"
682
In cases !here the -ricing level $ay re-resent a +avoura#le outco$e +or the
other -arty, the o++er $ay #e acce-te +ollo!ing a range o+ atte$-ts to secure
a lo!er -rice"
In the case o+ a re9ecte o++er, this $ay suggest that the #usiness $ay #e
una#le to continue a sustaina#le o-eration in the current +or$, an that a
change in the #usiness -roucts, o-eration or activities $ay #e neee"
5.25.1". 'lternatives to negotiation
4egotiation $ay #e a long an co$-le3 -rocess, an $ay involve
consiera#le cost an ti$e elays"
Also, e-ening on the a--roach taken #y the other -arty, other costs $ay #e
#orne"
In the case that the other -arty takes an a--roach #ase on a--lying sustaine
-ressure to the #usiness, this $ay involve a i++icult -rocess"
In so$e cases an aggressive a--roach $ay #e taken, !hile $ore co$$only
the o--osite a--roach o+ a +rienly a--roach $ay #e use, in co$#ination
!ith co$$ents criticising the ite$ or the iniviual conucting the
negotiation, in an atte$-t to secure a lo!er -rice"
A -ersonal cost $ay #e involve in resisting sustaine atte$-ts to secure
lo!er -rices"
'arious a--roaches $ay #e use as alternatives to a negotiation -rocess"
+i%ed prices
(oos $ay #e o++ere +or sale at +i3e -rices"
Retail goos $ay #e o++ere +or sale at +i3e, rather than negotia#le, -rices"
=o!ever, negotiation $ay #e use in the case o+ so$e large ite$s"
,ndependent price levels
Another a--roach $ay involve the -arties agreeing to use an ine-enent
re+erence -oint to set the -rice"
683
This coul involve so$e o+ the +ollo!ing a--roachesE
A $arket -rice o+ si$ilar goos, #ase on recent sales"
A +or$al valuation, or ine-enent e3-ertCs re-ort"
Alternatives to a sale #y negotiation $ay inclue auctions, inviting
su#$ission o+ teners, an a #iJo++erJcountero++er cycle #et!een t!o -arties
!ithout iscussions #eing involve"
4egotiation $ay #e unavoia#le in $any #usiness situations"
Many negotiations $ay -rocee through a set o+ si$-le ste-s an $ay #e
conclue !ithout any -articular i++iculty"
=o!ever, !hen a large or i++icult negotiation occurs, a !ell thought<out an
consistent a--roach $ay reuce the chance o+ an un+avoura#le outco$e +or
the #usiness
#.&. Business Opportunities
A range o+ alternatives $ay #e -ossi#le +or co$$encing a #usiness
o-eration"
These alternatives $ay inclue #uying an e3isting #usiness, starting a
traitional #usiness, an +or$ing a #usiness venture #ase on a ne! -rouct
or service"
5.2!.1. Bu$ing a business
Buying a #usiness $ay involve several avantages as a $etho o+
co$$encing a #usiness o-eration in co$-arison to other a--roaches"
This a--roach $ay involve a lo!er risk than atte$-ting a start<u- #usiness
activity"

Also, a long ti$e elay in the esta#lish$ent -hase o+ a start<u- #usiness $ay
#e avoie"
680
Businesses o+ all escri-tions $ay #e o++ere +or sale, ranging +ro$ -art<ti$e
cra+t o-erations to $a9or sections o+ $ultinational cor-orations"
The cost o+ a #usiness $ay #e #roken u- into t!o -arts"
The +irst -art o+ the cost covers the assets o+ the #usiness"
In the case o+ a s$all enter-rise, this $ay si$-ly #e the stock on han, an
-ossi#ly so$e other $inor ite$s such as o++ice e&ui-$ent"
In the case o+ larger organisations, this coul inclue $anu+acturing
+acilities, #uilings, an intangi#le assets such as licenses an -atents"
The secon -art o+ the cost is kno!n #y the accounting ter$ :goo!ill;"
This ter$ originally re+erre to the esta#lishe o-erations o+ the #usiness,
!hich $ay involve a value that is higher than the value o+ the irect assets"
In $ore general ter$s, this -art o+ the #usiness value $ay involve the
structure an on<going o-erations o+ the #usiness"
2or e3a$-le, a cash +lo!<#ase service #usiness $ay have very +e! assets,
#ut $ay have consiera#le cash +lo! an value ue to the regular o-erations
o+ the enter-rise"
In cases !here a #usiness has a sta#le an secure inco$e, a signi+icant cost
$ay #e re&uire to -urchase the #usiness"
In cases !here the #usiness inco$e is volatile or unsta#le, or the -revious
#usiness o!ner -er+or$e a large -art o+ the !ork -ersonally, there $ay #e a
lo! -re$iu$ to the asset value"
In so$e cases, such as o-erations in eclining inustries or -oorly<structure
an unsustaina#le #usiness o-erations, the sale -rice o+ a #usiness $ay
actually #e lo!er than the value o+ the assets"
Although -urchasing an e3isting #usiness $ay involve a range o+ #ene+its
co$-are to other a--roaches, the cost o+ a #usiness $ay generally #e
irectly relate to the sta#ility an the value o+ the net -ro+it"
5.2!.2. #tarting a business
68*
Asie +ro$ #uying an e3isting #usiness o-eration, an alternative a--roach
$ay involve +or$ing a ne! #usiness venture"
A start<u- #usiness enter-rise $ay involve consiera#le risk"
A large -ro-ortion o+ start<u- ventures +ail to reach a cash +lo! -ositive
-osition, an close !hen the availa#le +uns have #een s-ent"
=o!ever, this a--roach $ay also avoi the nee to -ay the aitional cost o+
the goo!ill -rice in -urchasing an e3isting #usiness"
Also, this a--roach $ay ena#le a #usiness to #e #uilt +ro$ the groun u-"
This a--roach $ay lea to $ore secure #asis +or +uture e3-ansion than a
#usiness -urchase in so$e cases, ue consistent evelo-$ent o+ the #usiness
accoring to a irection chosen #y the #usiness o!ner"
Also, valua#le lessons $ay #e learne an e3-erience $ay #e gaine uring
the start<u- -rocess"
5.2!.2.1.Tra(itional businesses
A #usiness venture $ay not nee to involve a ne! iea"
There $ay #e $any isavantages !ith starting a #usiness venture #ase on
a ne! iea"
A great eal o+ e3-eri$entation $ay #e re&uire to esta#lish an e++ective
$anu+acturing -rocess to service arrange$ent, an this $ay re&uire
consiera#le cost an ti$e elay"
Also, -otential custo$ers $ay not #e +a$iliar !ith the ne! -rouct or
service, an esta#lishing sales $ay #e a slo! an i++icult -rocess"
Starting a traitional #usiness $ay involve +or$ing a ne! #usiness venture
#ase on an esta#lishe ty-e o+ -rouct or service"
Starting a traitional #usiness o-eration $ay have a #ene+it in co$-arison to
starting a #usiness #ase on a ne! iea, in that the -rocesses an o-erations
o+ the #usiness $ay #e !ell esta#lishe, an that the necessary su--lies $ay
#e reaily availa#le"
68)
In an inustry !ith a large nu$#er o+ o-erations there $ay #e organisations
that are eclining, an e3isting #usiness o-erators !ho $ay !ish to e3it the
inustry +or one reason or another"
=o!ever, in so$e inustries such as restaurants, a large nu$#er o+ start<u-
o-erations $ay occur on a +re&uent #asis, an esta#lishing a sustaina#le
o-eration $ay e-en on $any issues"
5.2!.2.2.=e5 business onepts
Starting a #usiness #ase on a ne! -rouct or service $ay involve a higher
risk than other alternative a--roaches to co$$encing a #usiness o-eration"
,ong elays $ay #e involve in evelo-ing an e++ective $anu+acturing
-rocess or a -ractical service o-eration"
Su--lies $ay not #e availa#le +or certain ra! $aterials, an e&ui-$ent that
!as originally esigne +or other -ur-oses $ay have to #e aa-te to
$anu+acture the ne! -rouct"
Also, evelo-ing a sustaina#le level o+ sales $ay #e a slo! an i++icult
-rocess, ue to the nee to esta#lish the #ene+its o+ the ne! -rouct !ith
-otential custo$ers, rather than irectly co$-aring the -rouct against
e3isting -roucts"
=o!ever, there $ay also #e #ene+its !ith this a--roach"
In the case o+ a ne! -rouct or service, there $ay #e no irect co$-etitors"
The -rice o+ an ite$ $ay #e a critical +actor in esta#lishe $arkets !ith
$any co$-etitors"
In the case o+ a ne! ty-e o+ -rouct, the -rice level $ay #e less critical, an
the -rice $ay #e set accoring to the #ene+its o+ the -rouct an custo$er
interest, rather than e3isting $arket -rices"
Also, in so$e cases a ne! -rouct or service $ay solve a $a9or -ro#le$ that
occurs !ith -otential custo$ers, an the o--osite result $ay occur, !ith a
large volu$e o+ sales #eing orere !hen the -rouct is launche"
Alternatives +or ne! -roucts an services $ay inclue so$e o+ the
+ollo!ing ite$sE
688
Products for new industries
In the case o+ ne! inustries, the tools, -roucts an services that are use
$ay #e aa-te +ro$ other inustries, an $ay not #e +ully suita#le +or use
!ithin the ne! inustry"

$eplacements for e%isting products
In so$e cases, e3isting -roucts $ay #e #ase on i$-orte -roucts that are
not suita#le +or local conitions, or general<-ur-ose -roucts, !here creating
a s-eci+ic<-ur-ose -rouct $ay #e a su#stantial i$-rove$ent on the e3isting
availa#le -roucts"
In other cases, -roucts that are availa#le !ithin a -articular -rouct category
$ay #e #ase on esigns that $ay not have #een u-ate +or a signi+icant
-erio o+ ti$e"
Specialisation in a particular product group
In so$e situations, -roucts $ay #e $anu+acture as -art o+ a large grou- o+
relate -roucts"
In these cases, li$ite attention $ay #e -ai to the esign o+ a -articular
-rouct or s$all grou- o+ -roucts"
S-ecialisation in a -articular -rouct $ay allo! the #usiness to evelo-
-roucts that are #etter<esigne or are -rouce !ith a higher level o+
&uality than the -roucts that are currently availa#le +or sale"
Developing a product that applies to a small group of customers
=igh<volu$e $anu+acturing $ay re&uire that a s$all nu$#er o+ esigns #e
-rouce in large volu$es"
7ue to the s$all nu$#er o+ esigns an the #roa range o+ custo$ers, the
-rouct esigns $ay inclue the #asic +eatures that cover the essential
re&uire$ents across all custo$ers"
=o!ever, a s$all enter-rise $ay evelo- a -rouct or service +or a s-eci+ic
grou- o+ custo$ers, containing +eatures that !ere not availa#le in the large
scale general<-ur-ose ite$s"
681
Appl*ing new approaches and technolog* to e%isting products or
services
Technology such as co$-uter syste$s, an even the use #asic -roucts such
as +a3es an $o#ile tele-hones $ay take ecaes to +ilter through an
inustry"
In so$e cases, there $ay #e o--ortunities to use !ell<esta#lishe
technology in inustries that o not yet utilise the availa#le $ethos o+
-roucing -roucts or services"
5.2!.2.3.3a6age( business opportunities
In aition to start<u- enter-rises an -urchasing e3isting #usiness, #usiness
o-erations $ay #e co$$ence through a -ackage #usiness o--ortunity"
5ackage #usiness o--ortunities $ay involve a #usiness asse$#ling a range
o+ -roucts an services, esigne to +or$ the #asis +or co$$encing a
#usiness activity"
This $ay involve a single set o+ ite$s, or in $any cases it $ay involve an
on<going #usiness association !ith the -ackage -rovier"
A -ackage #usiness o--ortunity $ay inclue so$e o+ the +ollo!ing initial
ite$s"
Training $aterials, such as in+or$ation on -roucing the -roucts or
services, registration an insurance re&uire$ents, an so on"
,ists o+ -otential custo$ers an su--liers"
7esigns +or -roucing -roucts, such as clothing esigns"
As -art o+ an on<going activity, the -ackage -rovier $ay -er+or$ so$e o+
the +ollo!ing activities"
Su--lying ra! $aterials"
686
5urchasing co$-lete -roucts, +or istri#ution to other #usinesses
or custo$ers"
Avertising an -ro$otion, in the case o+ a #ran na$e use +or a
+ranchise o-eration"
Su--lying sales leas an contact in+or$ation +or -otential
custo$ers"
Su--lying -roucts to #e sol #y the #usiness to the general -u#lic"
5.2!.2.3.1. T$pes of pa6ages businesses
5ackage #usiness o--ortunities $ay inclue +ranchise o-erations"
In these cases, the #usiness o!ner $ay generally o-erate uner the #ran
na$e o+ the +ranchise organisation"
5roucts $ay #e su--lie, an the #usiness o!ner $ay -er+or$ services
accoring to the ty-e o+ #usiness"
This a--roach $ay #e use in so$e restaurants an +ast<+oo esta#lish$ents,
ho$e services such as cleaning an -ro-erty $aintenance, an so on"
In other cases, a #usiness $ay act as a istri#utor o+ the -roucts to the
general -u#lic"
This $ay not involve a +ull<ti$e #usiness o-eration, as $ay generally #e the
case in a +ranchise o-eration"
In this situation, the -ackage -rovier $ay su--ly the -roucts, an the
#usiness o!ner $ay sell the -roucts on an iniviual #asis or to regular
custo$ers"
2ees in these cases $ay #e #ase on a -ercentage o+ the sale -rice, +ees +or a
ti$e -erio such as a $onth, or so$e other arrange$ent"
5ackage #usiness o--ortunities $ay #e use in the case o+ -art<ti$e an
ho$e<#ase #usinesses"
This $ay inclue activities such as ty-ing services, s$all scale
$anu+acturing such as custo$ clothing orers, an so on"
610
5.2!.2.3.2. @ualit$ of pa6age( businesses
The structure an &uality o+ -ackage #usiness o--ortunities $ay vary
greatly +ro$ one situation to another"
So$e -ackage #usinesses $ay #e little $ore than con+ience sca$s"
In so$e cases, a large su$ o+ ca-ital $ay #e initially investe, +or virtually
no on<going #ene+it"
In so$e situations, the #usiness o-erator $ay +in that the #usiness activity
$ay result in an inco$e that $ay corres-on to a very lo! hourly rate"
In other cases, the -ackage #usiness $ay re-resent a !orth!hile o--ortunity"
=igh &uality $aterials an -roucts $ay #e su--lie, an +inishe -roucts
$ay #e -urchase #y the general -u#lic or the -ackage su--lier at -rices that
$ay allo! a strong return to #e receive +ro$ the #usiness activity"

5.2!.2.3.3. ,is6s of pa6ages businesses
T!o $a9or risks $ay #e involve in a -ackage #usiness o--ortunity"
In so$e cases, a consiera#le -ay$ent $ay nee to #e $ae to enter the
agree$ent an co$$ence the #usiness activity"
This $ay involve the right to use a #ran na$e uner a +ranchise agree$ent,
the -urchase -rice o+ e&ui-$ent, or a +ee +or access to in+or$ation such as
training guies or custo$er lists"
In the case o+ an unsuccess+ul #usiness activity, -art or all o+ the initial cost
o+ entering the #usiness $ay #e lost"
Also, in $any cases a contract $ay nee to #e signe #et!een the #usiness
o!ner an the -ackage -rovier"
The contract $ay s-eci+y etails o+ +ees an co$$ission rates, incluing +ees
that $ay #e -ai to the #usiness o!ner +or istri#ution -roucts, or +ees that
$ay #e -ai to the -ackage -rovier +or the use o+ the #ran na$e, +or
avertising e3-enses an so on"
611
Although these ter$s $ay #e stanar arrange$ents in so$e cases, +i3e
-erios o+ ti$e an cancellation -enalties $ay also a--ly"
In these situations, the contract $ay involve ter$s such as the re&uire$ent to
acce-t elivery o+ a $ini$u$ level o+ su--lies, +or a certain length o+ ti$e"
The contract $ay also inclue early ter$ination -enalties in the case that a
#usiness o!ner !ishes to e3it the arrange$ent #e+ore a -articular -erio o+
ti$e has -asse"
The inclusion o+ $ini$u$ ter$s, $ini$u$ volu$es, an e3it -enalties, $ay
re-resent a -otential risk to a #usiness o!ner consiering a -ackage
#usiness o--ortunity"
In the case that the #usiness o-eration is unsuccess+ul, or the #usiness o!ner
$ay #e +ace !ith the alternatives o+ !ithra!ing +ro$ the #usiness
o-eration an incurring a large loss, or continuing in a long ter$ arrange$ent
that $ay generate very little inco$e, an $ay not #e an activity that they
$ay !ish to continue"
5.2!.2.3.4. 'ssessing a pa6age( business opportunit$
In so$e cases, a -ackage #usiness o--ortunity $ay #e acco$-anie #y
clai$s o+ earning high levels o+ inco$e !ith the in-ut o+ very little ti$e or
e++ort"
In general, this situation itsel+ $ay -resent a !arning sign as to the
e++ectiveness o+ the #usiness o-eration"
=o!ever, !hile clai$s o+ -otential inco$e, sales +igures, -ro+its an so +orth
$ay #e consiere in assesse a #usiness o--ortunity, a sa+er a--roach $ay
involve -lacing little !eight on any in+or$ation regaring the -ossi#le level
o+ returns"
5.2!.2.3.4.1. Diret alulations
Dhere -ossi#le, in+or$ation regaring the cost o+ ra! $aterials, the cost o+
e&ui-$ent, an the sale -rice o+ -roucts shoul #e eter$ine #e+ore a
ecision is $ae to -rocee !ith a -ackage #usiness o--ortunity"
612
This in+or$ation $ay #e eter$ine +ro$ a sa$-le contract or su--ly
in+or$ation, or $ay #e re&ueste +ro$ the -ackage su--lier"
/o$-le3 calculations $ay not #e necessary in these situations"
In $any cases, a si$-le rule<o+<thu$# calculation $ay #e su++icient to
esti$ate the -otential inco$e an returns +ro$ a #usiness"
2or e3a$-le, the +ollo!ing +igures $ay #e eter$ine"
613
In-ut +igures
Ra! $aterial cost -er -rouct *
Sale -rice -er -rouct 8
/ost o+ e&ui-$ent 100
%sti$ates
5roucts -rouce -er hour *
2ro$ these +igures, the so$e o+ the +ollo!ing esti$ates $ay #e $ae
5ro+it -er ite$ P sale -rice I cost
P 8 I *
P G2
5ro+it -er hour P -ro+it 3 nu$#er o+ ite$s
P 2 3 *
P 10
Ti$e re&uire re-ay the e&ui-$ent cost (!ithout inco$e)
P total cost J -ro+it -er hour
P 100 J 10
P 10 hours
610
A range o+ #asic esti$ates an calculations such as these $ay esta#lish the
-ossi#le returns +ro$ a #usiness o-eration"
In so$e cases, this a--roach $ay not #e -ractical"
2or e3a$-le, the #usiness o!ner $ay #e reliant on the -ackage su--lier
su--lying !ork orers an custo$er re&uests, in orer to generate -rouction
volu$e"
In so$e situations, a -ro+it a$ount -er ite$ $ay #e ae&uate, ho!ever long
ti$e elays $ay occur #et!een orers, an the actual volu$e o+ ite$s that
$ay #e -rouce an sol over a -erio o+ ti$e $ay #e lo!"
(%isting "usiness operators
In so$e cases, a #usiness o!ner $ay #e a#le to s-eak to other clients o+ the
-ackage -rovier, to eter$ine the overall e++ectiveness o+ the #usiness
-rocess"
I+ a -ackage -rovier re+uses to su--ly etails o+ other clients +or -otential
contact, this $ay #e a negative sign as to the e++ectiveness o+ the #usiness
o-eration"
In+or$ation source in this !ay $ay not al!ays #e accurate"
In so$e cases, another #usiness o-erator $ay have a -oor vie! o+ a #usiness
o-eration, !hen in +act the #usiness $ay -resent signi+icant o--ortunities"
In other cases, a #usiness o-erator $ay s-eak highly o+ the #usiness
o-eration, +or one reason or another, !hen in +act the #usiness o-eration $ay
have serious e+iciencies"
=o!ever, a +e! short tele-hone calls $ay #e use+ul in gaining an i$-ression
o+ the res-onse o+ e3isting #usiness o!ners to the -ackage service"
-rial & error
In cases !here the initial cost invest$ent is not large, an early ter$ination
-enalties $ay not a--ly, the #usiness activity $ay #e atte$-te on a trial an
error #asis"
61*
In this situation, the #usiness activity $ay #e co$$ence, an the #usiness
o!ner $ay later !ithra! +ro$ the o-eration i+ the activity is unsuccess+ul"
This -rocess $ay also result in a consiera#le a$ount o+ e3-erience #eing
gaine, !hich $ay ena#le the #usiness o!ner to eter$ine the &uestions that
$ay nee to #e aske an the issues that $ay #e involve in selecting a
#usiness o--ortunity, an $ay #e a use+ul e3-erience in selecting a ne!
#usiness activity"
#.). 'i4ui(ity
,i&uiity relates to the ti$e elay that $ay #e involve in selling an asset"
,i&uiity $ay #e a signi+icant issue in #usiness o-erations"
2or e3a$-le, a #usiness $ay have consiera#le assets in e&ui-$ent,
#uilings an +acilities"
=o!ever, i+ an une3-ecte $a9or e3-ense arrives, the #usiness $ay #eco$e
insolvent i+ the availa#le cash holings are not large enough to $ake the
re&uire -ay$ent"
As an e3a$-le, a $a9or evelo-$ent -ro9ect $ay #e in -rogress"
A -rogress -ay$ent $ay #e e3-ecte +ro$ a client"
=o!ever, une3-ectely the client $ay #eco$e insolvent an e+ault on the
-ay$ent"
%3-enses $ay arise continuously as ti$e -rogresses, ho!ever cash reserves
$ay not #e availa#le to $eet the -ay$ents"
,i&uiity $ay also a $a9or issue in so$e inustries such as invest$ent
$anage$ent"
In general, selling a $a9or asset such as a -ro-erty or #usiness $ay involve a
$ini$u$ o+ several $onths #et!een the ti$e that the ecision is $ae to sell
the asset, an the ti$e that the +uns +ro$ the sale are availa#le +or use"
In the case o+ very large -ro9ects an #usinesses, this ti$e elay $ay e3ten
to several years"
61)
Several ste-s $ay #e taken in structuring a #usiness to reuce the chance o+
-ro#le$s arising ue to li&uiity issues"
5.27.1. 4nreasing t.e li9ui(it$ of assets
'arious ste-s $ay #e taken to reuce the ti$e elay that $ay #e involve in
selling assets"
These inclue so$e o+ the +ollo!ing -oints"
-radea"le securities
Traa#le securities inclue shares, liste #ons, an units in -ro-erty
invest$ent trusts"
,i&uiating s$all -arcels o+ traa#le securities $ay #e -ossi#le !ithin a +e!
ays, although in the case o+ large a$ounts, a longer ti$e elay $ay #e
involve"
=o!ever, unless the -arcel re-resente a large section o+ a co$-any, traa#le
securities $ay generally #e li&uiate !ithin a -erio o+ a +e! !eeks"
=oling ca-ital invest$ents in this !ay, as o--ose to alternatives such as
irect o!nershi- o+ -ro-erty or long<ter$ #ank e-osits, $ay allo! +uns to
#e raise at short notice +ro$ selling the assets"
/ultiple Assets
Selling large assets $ay involve a longer ti$e elay than selling s$all assets"
=oling #usiness assets in the +or$ o+ several s$all assets, rather than a
single large asset, $ay reuce the ti$e elay involve in selling an asset"
This a--roach $ay also have a #ene+it in ena#ling the #usiness to sell only
-art o+ the asset #ase, in contrast to a single large asset, !hich $ay involve
selling all or none o+ the assets"
2or e3a$-le, a #usiness $ay o-erate +ro$ several #uilings, or $aintain
several ite$s o+ e&ui-$ent, rather than o-erating a single large +acility"
618
A isavantage o+ this a--roach $ay #e that a large +acility $ay have $ore
e++icient o-eration an lo!er costs than several s$all +acilities"
5.27.2. 'voi(ing fi)e( assets
,i&uiity -ro#le$s $ay #e reuce #y leasing e&ui-$ent an -ro-erty rather
that o!ning assets"
This $ay allo! the ca-ital o+ the #usiness can #e store in $ore li&ui +or$s,
such as traa#le securities an cash #alances"
Also, altering e3-ense levels #y re<locating to larger or s$aller -re$ises $ay
#e one in a short -erio o+ ti$e an +or lo! cost in so$e situations, !here
#uilings are lease rather than o!ne"

5.27.3. ,aising fun(s
In so$e cases, +uns $ay #e raise !ithout selling the asset itsel+"
Secured lines of credit
A secure line o+ creit $ay involve an overra+t +acility that is secure
against an asset such as a -ro-erty or an ite$ o+ e&ui-$ent"
This $ay involve a loan that is availa#le +or the #usiness to ra! +uns +ro$
as re&uire"
7uring nor$al o-erations, the loan $ay not #e use"
=o!ever, i+ li&uiity -ro#le$s arose, +uns coul #e !ithra!n +ro$ the
+acility to $eet cash +lo! nees"
This $ay #e a valua#le +acility +or a #usiness to $aintain"
A secure line o+ creit $ay allo! the #usiness to raise +uns on short notice,
!ithout the ti$e elay an cost involve in selling an asset, an !ithout
loosing the asset itsel+"
Also, the +uns $ay only #e ra!n !hen they are neee, an there are $ay
#e no interest costs unless +uns are ra!n +ro$ the loan"
611
A +acility such as this $ay nee to #e arrange in avance, as this $ay not #e
-ossi#le a+ter a -ro#le$ has alreay occurre"
$aising de"t
In cases !here the cash +lo! o+ the #usiness re$ains strong, ho!ever cash
reserves are insu++icient to $eet large -ay$ents that $ay #e ue, e#t $ay
so$eti$es #e raise against an asset using a secure loan"
This a--roach $ay avoi li&uiity -ro#le$s that $ay result in ti$e elays
an costs in selling an asset, an $ay avoi the #usiness loosing the use o+
the asset itsel+"
3iring out assets
In so$e cases, cash +lo! $ay #e generate #y hiring an asset out to e3ternal
-arties, rather than selling it"
This $ay involve -er+or$ing contract $anu+acturing +or other -arties,
leasing -ro-erties +or short<ter$ uses such as seasonal #usiness activities, an
hiring out sur-lus e&ui-$ent on a short<ter$ #asis"
5.27.4. Business e9uit$
,i&uiity $ay #e a $a9or issue +or #usiness o!ners !ishing to !ithra!
+ro$ a #usiness enter-rise, an recover their +uns"
There are three +una$ental !ays that this can #e one"
.inding up the "usiness
Dining u- a #usiness $ay involve ceasing o-erations, selling the assets, an
re-aying outstaning e#ts"
This $ay #e one in cases !here the #usiness o!ner !ishes to cease #usiness
o-erations"
This a--roach to e3iting a #usiness activity $ay #e -articularly a--lica#le to
cases involving o-erations in a eclining inustry, o-erations !here the
616
#usiness o!ner -ersonally -er+or$e a signi+icant a$ount o+ the !ork, an
-ro9ect<#ase o-erations !hen a -ro9ect has #een co$-lete"
Selling the e)uit* stake
A secon alternative $ay involve the #usiness continuing in its -revious
+or$, !ith the #usiness o!ner selling their share o+ the #usiness to another
-arty"
In the case o+ a liste co$-any, this -rocess $ay #e relatively
straight+or!ar"
=o!ever, a ti$e elay $ay #e involve i+ a large -ro-ortion o+ the co$-any
is #eing sol, as this $ay not #e -ossi#le through traing irectly through the
$arket in a short -erio o+ ti$e, ue to a lack o+ su++icient #uying volu$e"
The shares $ay #e sol graually over a -erio o+ ti$e, or they coul #e
-lace in large #locks to institutional investors or other -arties, usually at a
iscount to the current -rice"
In the case o+ -rivate o-erations, selling an e&uity stake $ay #e $ore
i++icult"
Businesses $ay #e avertise +or sale through various -u#lications, an
#usiness #rokers $ay carry lists o+ #usinesses +or sale"
=o!ever, long ti$e elays $ay #e involve, an in so$e cases a #uyer $ay
not #e +oun +or a #usiness, or -art o+ a #usiness"
In the case o+ a -artnershi-, this a--roach $ay involve a -artner
!ithra!ing, an another -arty -aying +or the -artnershi- interest to 9oin the
-artnershi-"
Bu*ing "ack the interest
In cases !here the #usiness e&uity re-resents only -art o+ the o-eration, in
so$e cases the o-eration $ay #uy #ack the share o+ the #usiness using cash
+uns"
This e++ectively involves !ithra!ing the #usiness o!nerCs share o+ the
#usiness as cash, !ith the re$aining -arts o+ the #usiness continuing to
o-erate as #e+ore"
660
This o-tion $ay only #e availa#le in cases !hen the share o+ the #usiness
oes not re-resent a $a9or -art o+ the #usiness assets"
2or e3a$-le, a -artner $ay !ithra! +ro$ a -artnershi- #y taking their share
o+ the -artnershi- value in the +or$ o+ cash"
In the case o+ a co$-any, this $ay #e one through the co$-any -urchasing
the shares +ro$ the shareholer, an then cancelling the shares"
Dhen a larger -ro-ortion o+ the #usiness is involve, the sa$e -rocess coul
#e +ollo!e, !ith the shares #eing #ought #ack over a -erio o+ ti$e using
the cash +lo! +ro$ o-erations"
#.-. Sensitivity analysis
Sensitivity analysis involves eter$ining the e++ect that a change in one value
$ay have on another value"
This issue $ay #e relevant in $any areas o+ #usiness"
2or e3a$-le, in a #usiness !ith a high e#t level, the cash +lo! an net -ro+it
$ay #e highly sensitive to interest rates"
A rise in interest rates $ay result in a large reuction in cash +lo! an -ro+it,
!hile a +all in interest rates $ay have the o--osite e++ect"
Leverage
As a general rule, high sensitively $ay occur !hen leverage e3ists"
,everage $ay a--ly !hen t!o large nu$#ers are se-arate #y a s$all
$argin"
In the case o+ +inancial leverage, a large e#t an a large asset value $ay #e
se-arate #y a s$all net asset value"
In the case o+ o-erational leverage, inco$e an e3-enses $ay #oth #e high,
!ith a sli$ $argin o+ i++erence re-resenting net -ro+it"
In the case o+ -rouction leverage, a high -ro-ortion o+ costs $ay #e +i3e
costs"
661
In this situation, a rise or +all in sales $ay result in a large rise or +all in cash
+lo! an net -ro+it"
As an e3a$-le o+ leverage, a #usiness $ay have inco$e o+ G100 an
e3-enses o+ G61, +or a net -ro+it o+ G2"
I+ inco$e !as to +all #y 1L to G66, then net -ro+it !oul +all #y *0L to G1"
This is an e3a$-le o+ high sensitivity"
5.28.1. T.e signifiane of sensitivit$
The values that a #usiness o-eration $ay #e sensitive to, #y e+inition, $ay
#e the values that $ay -resent risk to the #usiness"
In $ost cases a variation $ay occur in either irection, an an averse $ove
in a sensitive in-ut $ay have a $a9or i$-act on the #usiness"
Sensitivity analysis $ay #e an i$-ortant -art o+ $oelling large -ro9ects, an
$anaging #usinesses !ith volatile in-uts or out-uts"
5.28.2. +alulating sensitivit$
Sensitivity can #e calculate in a nu$#er o+ !ays"
5.28.2.1.Diret alulation
In so$e cases, the out-ut result $ay #e calculate as a irect $ulti-le o+ the
in-ut result"
2or e3a$-le, the +ollo!ing sensitivities can #e calculate irectly"
/"pe Value
Affected
2ormula Description
Operational
sensiti4it"
'operationa
Gross cash
flo+
income
AAAAAAAAAA
income A expenses
/he multiple of change in cash
flo+ to change in either income
or expenses
662
l le4erage)
Asset
sensiti4it"
'financial
le4erage)
E!uit" 'Net
assets)
assets
AAAAAAAAAAAAAA
assets A de0ts
/he multiple of the change in
e!uit" to the change in asset
4alues
Interest
rate
sensiti4it"
Net cash
flo+
interest expense
AAAAAAAAAAAAAAAAAAAAA
net profit
/he multiple of change in net
profit, to change in interest
expense: A change in interest
rates from &; to ,; +ould lead
to %$; rise in the interest
expense
Input price
sensiti4it"
Gross cash
flo+
cost price per unit
AAAAAAAAAAAAAAAAAAAAAAAA
total cost per unit
/he multiple of the change in
total cost per unit, to the change
in the price of a ra+ material
Production
Sensiti4it"
'production
le4erage)
Net Profit units x 'unit sale price F unit 4aria0le cost)
AAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAA
units x 'sale price F unit 4aria0le cost) F fixed
costs
/he multiple of percentage
change in net profit to the
percentage change in production
4olumes:
/ime
Sensiti4it"
Net Profit
expenses
AAAAAAAAAAAAAAAAAAAA
income A expenses
/he multiple of the percentage
change in net profit, compared to
a percentage change in time
periods, +here income is fixed
and expenses are timeA
dependant:
Ta#le 3
(>> check -ercentage changes vs" ollar changes)
2or e3a$-le, in a case !here a #usiness ha assets o+ G*0 an e#ts o+ G00,
the asset -rice sensitivity !oul #e
debt assets
assets
multiple y sensitivit asset

00 *0
*0

*
In ollar ter$s, a change in asset values !oul have the sa$e ollar a++ect on
the net assets"
663
=o!ever, in -ercentage ter$s, a $ulti-le $ay a--ly"
The -ercentage change that occurs in one value as a result o+ a change in
another value $ay #e calculate using the +ollo!ing +or$ula"
change input multiple y sensitivit change output
2or e3a$-le, using the -revious +igures, the assets $ay rise +ro$ G*0 to G**"
The -ercentage change in the in-ut +igure $ay #e calculate using the
+ollo!ing +or$ula
100

value old
value old value ne(
change
In this e3a$-le, this calculation $ay -rouce the +ollo!ing +igure
100
*0
*0 **

change
10
The a++ect on the out-ut +igure $ay #e calculate using the sensitivity
a--roach"
2or e3a$-le, the -ercentage change in net assets coul #e calculate using
the +ollo!ing e3a$-le"
change 10 *
*0
660
The actual change in ollar ter$s $ay #e calculate using the +ollo!ing
+or$ula"
100
change percentage
amount original change actual
In this e3a$-le, this !oul #e
100
*0
10 change actual
* 5
5.28.2.1.1. Time sensitivities
Sensitivities $ay also #e a--lie to -erios o+ ti$e"
In the case o+ -ro9ect analysis using a net<-resent<value a--roach, a set o+
+uture inco$e an e3-ense cash +lo!s $ay #e iscounte to -resent values to
eter$ine a net -resent value o+ a -ro9ect"
This $etho is a +una$ental a--roach to eter$ining the value o+ any set o+
cash +lo!s"
In so$e situations, -ro9ect e3-enses $ay o-erate as a +i3e a$ount -er ti$e
-erio"
This $ay involve sta++ costs, rent, e&ui-$ent hire or e-reciation, an
interest costs"
In contrast, the inco$e +ro$ the -ro9ect $ay #e a +i3e ollar a$ount"
In situations such as these, a change in the ti$e -erio re&uire to co$-lete
the -ro9ect $ay lea to a change in the net -ro+it +ro$ the -ro9ect"
In situations involving a +i3e value o+ inco$e an involving ti$e<#ase
e3-enses, the sensitivity o+ the net -ro+it to changes in ti$e -erios $ay #e
calculate using the +ollo!ing +or$ula"
66*
enses exp income
enses exp
y sencitivit time

2or e3a$-le, a -ro9ect $ay involve the +ollo!ing +igures"

%3-enses 100
Inco$e 120
The ti$e sensitivity coul #e calculate using the +ollo!ing e3a$-le"
100 120
100

y sensitivit time
*
In this case, a -ercentage change in the ti$e re&uire to co$-lete the -ro9ect
$ay lea to +ive ti$es the -ercentage change in the net -ro+it +ro$ the
-ro9ect"
The change in net -ro+it $ay #e calculate using the +ollo!ing +or$ula"
change percentage time y sensitivit time change percentage profit net
2or e3a$-le, the ti$e re&uire +or the -ro9ect co$-letion $ay #e 10L a#ove
the scheule ti$e -erio"
In this case, the reuction in the net -ro+it +ro$ the -ro9ect $ay #e calculate
using the +ollo!ing e3a$-le"
66)
change percentage time y sensitivit time change percentage profit net
10 *
*0
This $ay #e illustrate using the +ollo!ing +igures"
Scheule Actual
%3-enses 100 110
Inco$e 120 120
4et 5ro+it 20 10
In this case, the e3-enses have increase #y 10L ue to the ti$e elay, !hile
the net -ro+it has reuce #y *0L"
The risks o+ losses occurring ue to ti$e elays $ay #e reuce in so$e
circu$stances #y &uoting a rate #ase on a $argin a#ove the costs that are
re&uire to actually co$-lete the -ro9ect"
=o!ever, a client $ay not !ish to acce-t the risk o+ increase costs #eing
incurre through ti$e elays"
In this situation, a client $ay o++er only a +i3e<-rice -ay$ent +or the -ro9ect,
or $ay only acce-t the -ro9ect evelo-$ent i+ the evelo-$ent contract
inclues a range o+ -enalties +or late co$-letion o+ the -ro9ect stages"
5.28.2.2.+orrelation
In so$e cases, the sensitivity an out-ut result to an in-ut value cannot #e
calculate irectly using a +or$ula"
2or e3a$-le, in the earlier e3a$-le o+ avertising an sales, the avertising
e3-ense $ay have a++ecte the sales +igures"
668
=o!ever, this link $ay #e #ase on -ro#a#ilities, rather than a irect ollar
change, as $ay a--ly in the case o+ a change in ra! $aterials costs"
In so$e cases, a regression can #e use to eter$ine the sensitivity o+ an
out-ut +igure to an in-ut +igure"
The regression -rocess $ay -rouce an e&uation in the +ollo!ing +or$
b value input a value output +
In this +or$ula, the value :a; coul #e use to esti$ate the likely ollar
change in an out-ut value +or a ollar change in the in-ut value"
This $ay #e re-resente #y the +ollo!ing +or$ula
input in change dollar a output in change dollar
The sensitivity $ulti-le $ay #e calculate using the +ollo!ing +or$ula"
value output
value input
a multiple y sensitivit
2or e3a$-le, in the -revious case o+ the avertising +igures, the value o+ :a;
!as 0"10"
This i$-lies that a one<ollar change in the avertising e3-ense $ay lea to a
0"10 ollar change in sales
In a case !here the current avertising level !as G1* an sales !ere G100,
the $ulti-le coul #e calculate using the +ollo!ing e3a$-le"
100
1*
10 0 . multiple y sensitivit
661
12) 0.
In this e3a$-le, a change in avertising e3-ense at this level o+ sales $ay
lea to 0"12) ti$es the -ercentage change in sales"
2or e3a$-le, i+ the avertising e3-ense !as increase #y 20L, then the
-ercentage change in sales $ay #e calculate +ro$ the +ollo!ing e3a$-le"
change input multiple y sensitivit change output
20 12) 0 .
.*2 2
5.28.3. -o(elling
In the case o+ co$-le3 -roucts an organisational structures, co$-uter
$oels $ay #e create to eter$ine the out-ut +igures #ase on the in-ut
costs"
2or e3a$-le, in a $ining -ro9ect, a $oel $ay inclue the costs o+
e&ui-$ent, sta++ costs, su--ly costs an so on"
The out-ut $ay then #e #ase on the volu$e o+ -rouction, the -ercentage o+
the $ineral that occurre !ithin the #ulk ore, in-ut costs an so +orth"
Sensitivity analysis o+ $oels o+ this ty-e $ay #e -er+or$e #y altering the
in-ut +igures, an eter$ining the -ercentage change that results in the
out-ut +igures"
In so$e cases there $ay #e irect a $ulti-le a++ect, !hile in $ore co$-le3
situations such as che$ical -rouction or +inancial instru$ents, the out-ut
a++ect $ay rise or +all e-ening on the conition o+ other varia#les"
A :Monte /arlo; si$ulation $ay involve generating a large nu$#er o+
rano$ values, an eter$ining the resulting out-ut values +or a set o+
rano$ in-uts"
666
2or e3a$-le, in the $ining case, rano$ values $ay #e generate +or the
-ercentage o+ the $ineral !ithin the ore, +uel costs, an -rouction volu$es"
This $ay then -rouce a statistical istri#ution o+ the out-ut o+ the -ro9ect,
!ith the likely !orse<case, average, an #est case results +ro$ the -ro9ect"
The Monte /arlo si$ulation a--roach $ay #e use in -ro9ects !ith $any
volatile in-uts, such as $ining -ro9ects, an in the valuation o+ so$e
co$-le3 +inancial $arkets instru$ents an -ort+olios"
5.28.4. -anaging sensitivities
Ance the sensitivities have #een eter$ine, an a--roach +or $anaging the
#usiness $ay #e eter$ine"
In the case o+ in-uts that o not cause high sensitivity, these can #e $anage
as stanar costs"
All costs $ay i$-act on the #usiness, an even s$all costs $ay nee to #e
$anage e++ectively"
In so$e situations, the total cost $ay si$-ly #e a collection o+ $any s$all
costs, !hich $ay accu$ulate to a large total cost"
In these situations, $anaging each cost e++ectively, incluing s$all costs,
$ay #e necessary in orer to -revent the total costs +ro$ #eco$ing
e3cessively high"
=o!ever, in the case o+ in-uts causing -articular sensitivity, these values
$ay nee s-eci+ic action"
A--roaches +or $anaging risk e3-osures to sensitive in-uts $ay inclue
so$e o+ the +ollo!ing -ossi#le a--roaches"

Hsing heging techni&ues such as +utures contracts, o++setting risks,
an sourcing su--lies in the sa$e currency as sales to reuce the
e3-osure to values such as currency e3change rates an co$$oity
-rices"
4egotiating $eiu$<ter$ +i3e<-rice contracts !ith su--liers or
custo$ers"
1000
Altering -ricing arrange$ents to -ass a volatile in-ut -rice through
to the +inal -rice o+ the -rouct"
Hsing o-tions to allo! -rices to #e +i3e in avance, !ithout the
nee to enter a contract #e+ore the +uture stages o+ the -ro9ect are
kno!n"
Ouoting -rices as a $argin on costs, rather than a +i3e -rice
contract" This arrange$ent $ay #e use, +or e3a$-le, in areas such
as construction, !here a client $ay re&uest a &uote -rice +or a
-ro9ect such as constructing a #uiling"
,i$iting e3-osure to -articular values #y incluing clauses in client
agree$ents that s-eci+y that a -rice $ove a#ove a certain li$it $ay
#e -asse through to the client"
Arranging !ith other -arties to take on certain risks in return +or
+ees"
Taking action to reuce sensitivities, such as reucing e#t levels or
increasing $argins, to reuce the risk that changes in values $ay
have a $a9or negative i$-act on the #usiness"
5.28.5. :ariable sensitivities
In so$e cases, a sensitivity $ay not #e constant, #ut $ay vary as the
unerlying +igures increase or ecrease"
(>> check conitions +or +i3eJvaria#le sensitivities)
In these cases, a sensitivity $ay #e use to esti$ate the a++ect o+ a s$all
change in an in-ut value"
=o!ever, a large change in an in-ut value $ay lea to a i++erent result than
$ay #e e3-ecte +ro$ a sensitivity calculation"
2or this reason, sensitivities $ay not accurately re+lect the risk e3-osure o+
the #usiness to large changes in in-ut values"
In these situations, re<calculating the out-ut values +or i++erent sets o+ in-ut
values, rather than using sensitivity $ulti-les, $ay #e use to eter$ine the
e++ect on out-ut values o+ large changes in in-ut values"
1001
#... Business e8pansion
In so$e situations, a #usiness o-eration $ay re$ain sta#le +or an e3tene
-erio o+ ti$e"
This $ay occur in cases in !hich the #usiness o!ners $ay #e -ersonally
involve in the o-erational activities o+ the #usiness, an in situations such as
success+ul single<-rouct co$-anies"
In other cases, a #usiness $ay e3-an continuously over ti$e, evelo-ing
ne! -roucts, an co$$encing o-erations !ithin ne! $arkets"
Businesses $ay also contract in si@e an o-erations over ti$e"
This $ay occur in the case o+ eclining inustries, highly co$-etitive
inustries, an in cases !here the #usiness o!ner $ay loose interest in
o-erating an evelo-ing the #usiness"
5.29.1. Operational problems
In cases !here a #usiness is e3-eriencing o-erational -ro#le$s, these
-ro#le$s $ay nee to #e aresse #e+ore any e3-ansion o-tions are
consiere"
=o!ever, e3-ansion $ay #e consiere in the case o+ a success+ul o-eration,
!hile in so$e circu$stances, e3-ansion activities $ay solve an e3isting
-ro#le$ !ithin the #usiness o-eration"
2or e3a$-le, a #usiness $ay have overca-acity an $ay o-erate high<
ca-acity -rouction +acilities that are not +ully utilise"
In this case, e3-aning sales $ay lea to i$-roving returns, +ro$ increasing
the utilisation o+ the +acilities"
5.29.2. E)pansion
Business e3-ansion $ay #e a !orth!hile activity in a nu$#er o+
circu$stances"
1002
This $ay inclue so$e o+ the +ollo!ing situations"
Strong cash flow
In the case o+ a success+ul #usiness o-eration, a nu$#er o+ a--roaches $ay
#e taken"
/ash +lo! $ay #e irecte to!ars increase ivien -ay$ents"
=o!ever, re<invest$ent in ne! -roucts, -ro9ects an +acilities $ay also #e
necessary to ensure that the #usiness o-eration continues to re$ain
-ro+ita#le"
So$e -roucts $ay evelo- a sta#le long<ter$ sales -attern"
=o!ever, in general the $arkets +or -roucts $ay change continually, an a
#usiness that oes not continually change $ay +in that sales enter a long<
ter$ ecline a+ter a -erio o+ ti$e"
In situations !ere cash +lo! is strong, e3-aning the #usiness activity $ay
also #e consiere"
3igh fi%ed costs
In the case o+ a #usiness !ith high +i3e costs, such as e3-ensive high<
ca-acity -rouction +acilities, increasing volu$es $ay lea to increase
-ro+ita#ility, as the +i3e costs $ay #e a#le to #e s-rea across a larger
nu$#er o+ units"
0nused capacit*
In cases !here a #usiness has -rouction or service elivery ca-acity that is
currently unuse, engaging in e3-ansion activities $ay ena#le the +ull
ca-acity o+ the +acilities to #e use, an i$-rove the -ro+ita#ility o+ the
#usiness"
Declining4 consolidating and highl* competitive industries
In so$e cases, an e3isting #usiness o-eration $ay #e una#le to evelo- a
steay net -ro+it ue to the conitions !ithin the region or the inustry in
!hich it o-erates"
1003
5o-ulation $ay #e eclining !ithin a local area, an inustry $ay #e
consoliating into high e++iciency -rouction +acilities !ith lo! costs an
lo! -rices, or co$-etition $ay #e -articularly intense !ithin the inustry,
!ith co$-etitors o++ering #reak<even or loss<$aking -rices"
In situations such as these, an e3isting #usiness o-eration $ay #e
unsustaina#le in its current +or$"
A #usiness in a situation such as this $ay engage in e3-ansion activity, in an
atte$-t to esta#lish a i++erent #usiness activity that $ay o-erate on a
sustaina#le #asis"
5.29.3. Organi gro5t. :s a9uisition
Business e3-ansion $ay #roaly +ollo! t!o -athsB organic gro!th, an
gro!th #y ac&uisition"
Arganic gro!th $ay involve the graual e3-ansion o+ an e3isting #usiness
o-eration"
Ac&uisition $ay involve e3-aning the #usiness #y -urchasing other
#usinesses"
1rganic growth
Arganic gro!th $ay involve gro!ing the #usiness #y e3-aning the #usiness
enter-rise"
This -rocess $ay involve evelo-ing ne! -roucts an services, an
e3-aning sales volu$es through $arketing activities, an though #eing a#le
to o++er co$-etitive -rices ue to e++icient o-erations"
Dithin inustries in !hich econo$ies o+ scale $ay a--ly, organic gro!th
$ay lea to a cycle o+ rising volu$es, reucing costs -er unit, invest$ent in
higher ca-acity -rouction +acilities an continue rises in sales levels"
This -rocess $ay result in so$e inustries consoliating into a s$all nu$#er
o+ large organisations"
In other cases, organic gro!th $ay occur through e3-aning sales into !ier
areas, launching ne! -roucts, an entering ne! inustries or $arkets"
1000
Ac)uisition
(ro!th #y ac&uisition $ay involve -urchasing other #usinesses"
This $ay involve the -ay$ent o+ a goo!ill cost, !hich $ay not #e
necessary in the case o+ organic gro!th"
=o!ever, ac&uisition $ay ena#le a #usiness to $ake large lea-s in si@e in a
short -erio o+ ti$e, an $ay #e a use+ul a--roach +or co$$encing activities
in ne! $arkets or inustries"
This $ay -articularly a--ly in the case o+ entering inustries in !hich
econo$ies o+ scale $ay a--ly"
In these situations, co$$encing a s$all o-eration an graually e3-aning
$ay not #e a via#le o-tion, as the s$all o-eration $ay not #e a#le to o-erate
!ith e&uivalent costs an -rices to the large e3isting o-erations"
This situation $ay #e aresse through -urchasing an e3isting #usiness that
is esta#lishe !ithin the inustry"
Ac&uisition $ay #e use+ul in ac&uiring ne! technology, !hich $ay #e
co$#ine !ith e3isting o-erations to increase the e++iciency o+ the e3-ane
#usiness enter-rise"
So$e inustries $ay involve a sta#le nu$#er o+ #usiness o-erations"
Although the inustry $ay o-erate on a -ro+ita#le #asis, the level o+ -ro+its
$ay #e su++icient to $aintain e3isting o-erations, #ut not high enough to
+un e3-ansion activities"
In these cases, e3-ansion through organic gro!th $ay #e i++icult"
This situation $ay #e aresse through raising ca-ital to -urchase other
#usinesses, an to e3-an custo$er nu$#ers an sales #y using an
ac&uisition a--roach"
This $etho $ay -articularly a--ly !ithin inustries in !hich econo$ies o+
scale o not a--ly, such as so$e service inustries that $ay involve a large
nu$#er o+ s$all iniviual #usinesses !ith se-arate client #ases"
100*
5.29.4. :ertial & .oriAontal integration
=ori@ontal gro!th $ay involve e3-aning sales an custo$er nu$#ers
!ithin the level o+ the inustry in !hich the #usiness o-erates"
A #usiness $ay #e involve so$e o+ the +ollo!ing activities"
1" 5ri$ary -rouction such as $ining or +ar$ing"
2" Su--ly o+ ra! $aterials"
3" 5rouction o+ #asic su--lies"
0" 5rouction o+ co$-le3 -roucts"
*" Dholesale istri#ution to other #usinesses"
)" Retail istri#ution to the general -u#lic"
This se&uence o+ ste-s, +ro$ e3traction o+ #asic su--lies through to elivery
o+ +inishe -roucts, $ay #e kno!n as the su--ly chain o+ an inustry"
'ertical integration $ay involve a #usiness o-erating activities at a nu$#er
o+ levels !ithin the su--ly chain"
2or e3a$-le, a +oo $anu+acturer $ay conuct +ar$ing o-erations, -rouce
+oo -roucts, an istri#ute -roucts to the general -u#lic"
Ane argu$ent that $ay #e use in +avour o+ this a--roach $ay involve the
+act that a -ro+it $argin $ay not nee to #e -ai to su--liers in other stages
o+ the su--ly chain, !hen the #usiness conucts the activities irectly"
=o!ever, this $ay #e a +la!e argu$ent"
%ach stage in the o-eration $ay re&uire invest$ent in ca-ital e&ui-$ent an
-ro9ects, on<going e3-enses, an $anage$ent o+ the #usiness activity"
In e++ect, #y o-erating at several levels in the chain, a #usiness $ay si$-ly
o-erate several ine-enent #usiness o-erations"
There $ay not #e an auto$atic #ene+it in this a--roach"
100)
In cases !here the return on the invest$ent !as the sa$e at each level in the
chain, the sa$e result coul #e achieve #y allocating the entire #usiness
resources to o-erations !ithin a single level o+ the su--ly chain"
=o!ever, there $ay #e a nu$#er o+ -otential avantages an isavantages
!ith a vertical integration a--roach"
This $ay inclue so$e o+ the +ollo!ing -oints"
Advantages
(reater control over &uality an relia#ility o+ su--lies"
5ossi#le increase -ro+it $argins !hen one stage in the -rocess,
such as a ste- in the istri#ution -rocess, collects +ees #ut oes not
a signi+icant #ene+it to the -rouction -rocess"
Disadvantages
5otentially $ore co$-le3 o-erations, !ith the nee to $anage
several i++erent #usinesses, !here each #usiness $ay involve
i++erent issues +ro$ the other #usinesses"
An ina#ility to increase or ecrease su--ly volu$es +ro$ early
stages in the chain, !hen sales levels rise or +all" This $ay lea to a
shortage o+ su--lies uring ti$es o+ high sales, an high costs ue to
unuse ca-acity uring ti$es o+ slo! sales"
5.29.5. E)pansion ativities
A nu$#er o+ activities $ay #e involve in e3-aning the #usiness o-erations"
This $ay inclue so$e o+ the +ollo!ing -oints"
Avertising an -ro$otion /onucting avertising an -ro$otion
ca$-aigns $ay lea to increase sales"
Regular on<going avertising $ay ena#le
the #usiness to #uil a #ran na$e -ro+ile,
an $ay lea to a steay e3-ansion o+ the
#usiness activity"
1008
%ntering ne! $arkets 4e! $arkets $ay involve creating ne!
-rouct lines !ithin an inustry, such as the
esta#lish$ent o+ large<scale -rouction o+
#asic ite$s, #y a #usiness that $ay have
#egun !ith the -rouction o+ lo! volu$e,
high $argin s-ecialty an custo$ise
ite$s" 4e! $arkets $ay also involve ne!
geogra-hic areas an ne! inustries"
4e! -roucts 4e! -roucts $ay #e create to re-lace ol
-rouct lines, an to #egin -rouction o+
-roucts that the #usiness has not
-reviously sol"
4e! inustries In cases !here a #usiness $ay have a large
$arket share !ithin an inustry, !here
organic e3-ansion $ay #e i++icult, or
!hen co$-etition $ay #e intense an -ro+it
levels $ay #e lo!, the #usiness $ay
e3-an activities into ne! inustries" This
$ay involve -urchasing another #usiness,
creating a start<u- o-eration, or graually
co$$encing o-erations in a ne! inustry"
(eogra-hic e3-ansion Sales o+ the #usinessCs -roucts an
services $ay #e e3tene to interstate an
overseas $arkets" This $ay involve
e3-orting -roucts, -er+or$ing services +or
overseas clients, or esta#lishing o-erations
in other states or countries"
#.!0. Cash flo% maps
The structure an o-erations o+ a #usiness $ay #e re-resente in a !ie
variety o+ iagra$s an gra-hical +or$ats"
The +ollo!ing +or$at -resents one alternative +or illustrating the cash +lo!s
#et!een $a9or co$-onents o+ a #usiness o-eration"
Although this iagra$ involves a -icture o+ cash +lo!s, the value trans+er ue
to the e-reciation e3-ense is also inclue !here it is signi+icant"
1001
This iagra$ $ay corres-on to an organisational structure, or it $ay si$-ly
#e a $etho o+ analysing the $a9or co$-onents o+ the #usiness +inancial
structure"
In this iagra$, the ele$ents have the +ollo!ing escri-tions
Avals Internal co$-onents o+ the #usiness" %ach oval corres-ons
to a $a9or ine-enent +unction o+ the #usiness o-eration"
The ovals have the +ollo!ing +or$at"
=eight I the value o+ the assets !ithin the co$-onent"
Dith I the nu$#er o+ e$-loyees relate to the co$-onent"
,ine thickness I the value o+ cash +lo!ing through the
co$-onent"
In this case, the cash +lo! re+ers to the inco$e an e3-enses
o+ o-erating the area, not the volu$e o+ -ay$ents that $ay #e
-rocesse or goos that $ay #e trans-orte"
Bo3es %3ternal -arties to the #usiness" This inclues e$-loyees,
su--liers an custo$ers, to escri#e cash +lo!s ue to
salaries, su--ly costs an so +orth"
7ia$ons The value o+ assets, re+lecting the rain o+ the e-reciation
e3-ense"
,ines /ash +lo!s or value trans+ers #et!een co$-onents" The
thickness o+ the line re-resents the si@e o+ the cash +lo!s"
'arious si@es an thicknesses $ay not #e to scale, ho!ever they $ay #e in
-ro-ortion to the relative si@es o+ each co$-onent"
Anly $a9or cash +lo!s are inclue, an sta++ costs or e-reciation are not
inclue +or co$-onents !here they $ay re-resent a $inor ele$ent o+ the
cash +lo!s or value trans+ers"
The #usiness in this e3a$-le is a $anu+acturing o-eration, an has the
+ollo!ing co$-onents
/or-orate centre The +uning centre +or raising ca-ital an
1006
istri#uting interest, iviens an holing
e&uity +uns"
A$inistration .
general services
5rocessing o+ custo$er -ay$ents, registers o+
assets an so on
Manu+acturing 5rouction o+ -roucts" This section sells goos
on a !holesale #asis to the sales an istri#ution
area, an also receives inco$e +ro$ -re+or$ing
contract $anu+acturing +or e3ternal -arties"
Sales . istri#ution This area sells -roucts to custo$ers, !ith
!holesale -rices #eing -ai to the
$anu+acturing o-eration"
7esign centre A esign centre that -rouces -hysical esigns
+or -roucts, an receives licence +ees +ro$ the
$anu+acturing o-eration"
5o!er generation A se-arate -o!er generation +acility generates
-o!er +or the $anu+acturing o-eration, an also
receives inco$e +ro$ elivering -o!er into the
regional su--ly gri uring ti$es o+ -eak -rices
an e$an"
1010
A$in
Manu+a
cturing
Sales
/or-orate
/entre
5o!er
(eneration
/usto$ers
Manu+acturing
/lients
Manu+acturing
%&ui-$ent
(enerating
%&ui-$ent
7esign /entre
,icence
2ees
7e-reciation
5o!er gri ,eners
Shareholers
Interest
7iviens Sale o+
-o!er
7e-reciation
%$-loyees %$-loyees
%$-loyees
%$-loyees
Materials Su--liers
2uel
G 123
G 0*)
G 816
G 323
1011
#.!1. 3ractical aspects of commencing business
5.31.1. +onept
/o$$encing a #usiness activity $ay involve #eginning !ith a #roa conce-t
in $in o+ the ty-e o+ #usiness that $ay #e o-erate, an the si@e an sco-e
o+ the #usiness o-eration"
This $ay involve ieas ranging +ro$ -art<ti$e cra+t activities, to
co$$encing a #usiness o-eration !ith an ai$ o+ long ter$ evelo-$ent an
e3-ansion o+ a #usiness enter-rise"
Initial ieas $ay also involve the o-tion o+ -urchasing an e3isting #usiness,
or co$$encing a start<u- o-eration"
5urchasing a #usiness $ay #e a !orth!hile o-tion !hen the ai$ o+ the
#usiness activity is to o-erate a sta#le long<ter$ activity"
Businesses such as a con+erence centre !ith acco$$oation an $eals
+acilities $ay #e o-erate on this #asis"
In the case o+ long ter$ e3-ansion, a start<u- #usiness activity $ay #e
suita#le, ue to the lessons that $ay #e learne an the skills that $ay #e
evelo-e in #uiling a #usiness +ro$ a @ero starting -oint"
5.31.2. ,esear.
A consiera#le a$ount o+ research $ay #e involve in the -rocess o+
-re-aring to co$$ence a #usiness activity"
This $ay involve locating in+or$ation a#out the -articular inustry o+ the
activity, $a9or issues that $ay #e involve in o-erating a #usiness o+ that
-articular ty-e, an so on"
This $ay also involve in+or$ation concerning #usiness activity in general,
such as $anaging +inancial arrange$ents, legal issues an so on"
An investigation o+ the ty-es o+ #usinesses that $ay #e o++ere +or sale, an
the various -rices, $ay also #e necessary in orer to select an a--ro-riate
1012
#usiness to -urchase, or in orer to esti$ate the costs an -otential inco$e o+
a start<u- o-eration"
5.31.3. /un(ing
2uning $ay #e a $a9or issue in co$$encing a #usiness activity"
This $ay involve arranging #ank loans as a -ersonal #orro!er, an locating
other -arties to invest in the enter-rise, either through lening +uns, or as
-art<o!ners o+ the #usiness as e&uity investors"
A #orro!ing arrange$ent $ay have a #ene+it o+ allo!ing o!nershi- an
control to re$ain !ith the initial #usiness o!ners"
=o!ever, this $ay also re&uire regular interest -ay$ents, !hich !oul not
#e necessary in the case o+ an e&uity invest$ent"
Also, investors $ay not #e !illing to loan $oney ue to the risks involve
an the li$ite return +ro$ interest, an $ay -re+er an e&uity arrange$ent
that $ay involve a -ro<rata share o+ the #usiness -ro+its"
5.31.4. Business struture
In co$$encing a #usiness activity, a #usiness structure $ay nee to #e
selecte"
Ma9or alternatives $ay inclue so$e o+ the +ollo!ing o-tions"
/o$-any Assets are o!ne in the na$e o+ the co$-any, an
the #usiness o!ners hol shares in the co$-any"
Iniviual Assets are o!ne -ersonally in the na$e o+ the
#usiness o!ner"
5artnershi- Assets are o!ne in 9oint na$es, in the na$es o+
the -artners" (>> check asset title registration +or
-artnershi-s)
1013
A co$-any $ay #e suita#le +or #usiness enter-rises involving $ore than t!o
or three #usiness o!ners, or in the case o+ a signi+icant si@e #usiness
o-eration"
=o!ever, the -ractical ste-s involve in trans+erring ca-ital into an out o+ a
co$-any, an a nu$#er o+ -roceural re&uire$ents such annual returns an
annual $eetings, $ay lea to a co$-any structure #eing cu$#erso$e +or an
iniviual enter-rise"
5.31.5. Bu$ing a business
In the case o+ #uying a #usiness, in+or$ation $ay #e source +ro$ #usiness
#rokers an -u#lications regaring #usinesses +or sale"
An e3tene -erio o+ ti$e $ay #e necessary in orer to #eco$e +a$iliar
!ith the ty-es o+ #usinesses availa#le, an the o-tions that $ay #e o-en +or
the #usiness o!ner to co$$ence a #usiness o-eration"
5.31.!. 3rofessional servies
Business o-erations $ay eal !ith various -arties in the course o+ #usiness
activities"
7iscussions an transactions $ay involve custo$ers, clients, su--liers an
e$-loyees"
In the case o+ -ro+essional services, the +ollo!ing areas $ay #e involve"
Accounting An accountant $ay -re-are ta3 returns, -re-are
+inancial state$ents, an -ossi#ly avise on
+uning an other +inancial issues"
,egal A solicitor $ay ra! u- contracts, e$-loy$ent
agree$ents, leases, $ortgages an so on" A
solicitor $ay also avise on the legal o-tions that
$ay #e availa#le in various circu$stances, avise
on ste-s that $ay #e taken to reuce legal risks, an
-re-are cases involving legal action against other
-arties, or e+ences to legal action"
1010
Banking A #usiness $ay eal !ith a contact at a #ank
regaring loans, overra+t +acilities, an so on"
5.31.7. 4nsurane
In so$e cases, insurance o+ various ty-es $ay #e legally re&uire #e+ore a
#usiness $ay co$$ence o-eration"
In other cases, arranging various ty-es o+ insurance $ay #e -ruent ste-
#e+ore co$$encing o-erations"
Insurance in these circu$stances $ay involve insurance involving in9ury o+
e$-loyees, regaring $eical e3-enses an lost inco$e"
Ather insurance $ay inclue #uilings an contents, -u#lic lia#ility
insurance against legal action, an so on"
5.31.8. ,egistration & lienses
A nu$#er o+ registration an licensing ste-s $ay #e re&uire, e-ening on
the ty-e o+ #usiness"
2or$ing a co$-any $ay involve co$-leting a registration +or$, an
-ay$ent o+ an initial +ee an an annual +ee"
A #usiness $ay nee to #e registere !ith ta3 authorities, e-ening on the
-articular situation"
,icences to o-erate $ay also #e re&uire in so$e inustries, an $ay involve
a--lications to a local council, or a--lications to state or national regulatory
authorities"
#.!. 6iscellaneous business ris+s
5.32.1. :aluations
5.32.1.1.Brite*(o5n ris6
101*
.rite-downs
'aluation is an area o+ risk $anage$ent that can have a signi+icant i$-act on
a #usiness o-eration"
In so$e cases, a $a9or !rite<o!n in the value o+ an asset can lea to the
colla-se o+ a #usiness"
Dhen a $a9or !rite<o!n in the value o+ a signi+icant asset occurs, the
structure o+ the #alance sheet an the gearing ratios $ay eteriorate
signi+icantly"
In this situation, rolling over e#t or raising +uns to continue o-eration $ay
#eco$e i++icult or i$-ossi#le"
Asset values
This risk -articularly a--lies to the valuation o+ non<-hysical assets"
This inclues the valuation -lace on -ro9ects, valuations #ase on +uture
inco$e strea$s, valuation o+ #ran na$es an intangi#le assets, an the
value -lace on +inancial traing #ooks"
These assets $ay have a su#9ective an highly varia#le value, !ith a change
in valuerCs o-inions, valuation assu$-tions or valuation $oels leaing to a
large change in the valuation o+ the asset"
5.32.1.2.,e(uing 5rite*(o5n ris6
Dhere assets carry a signi+icant value in the #alance sheet, various ste-s $ay
#e taken to reuce the risk o+ a $a9or !rite<o!n occurring"
This $ay inclue so$e o+ the +ollo!ing a--roaches"
$ule-of-thum" verification
Dhere -ossi#le, a rule<o+<thu$# a--roach $ay #e use to veri+y that a
valuation is !ithin a realistic range"
A consiera#le a$ount o+ ti$e an e++ort $ay #e involve in -re-aring a
etaile valuation"
101)
=o!ever, in $any cases a co$-arison !ith other assets, or a si$-le
calculation, $ay #e use to ensure that the valuation +igure is !ithin a
#roaly reasona#le range"
2or e3a$-le, a etaile valuation o+ a #usiness $ay #e conucte #ase on
the #usinessCs $argins, assets, the $arkets +or the #usinessCs -roucts an so
on"
A se-arate orer<o+<$agnitue check o+ the valuation coul involve a
calculation such as a $ulti-le o+ the current net -ro+it"
As an e3a$-le, a $ulti-le o+ eight ti$es net -ro+it coul #e use to calculate
an a--ro3i$ate value +or the #usiness #eing value"
In so$e cases, such as the valuation o+ co$-le3 instru$ents an traing
-ort+olios, #roa checks o+ the valuation $ay not #e -ractical"
In these situations the auiting an revie! o+ valuation a--roaches $ay
#eco$e -articularly i$-ortant"
Auditing models
In cases !here a valuation is erive +ro$ a $oel, an ine-enent auit o+
the assu$-tions, structure an o-eration o+ the $oel $ay #e conucte"
'aluation $oels are use to value +uture inco$e strea$s, uncertain values
such as -ro9ect cash +lo!s, an traing instru$ents in situations such as
heging -ort+olios"
A valuation auit coul #e -er+or$e #y an e3ternal -arty, or #y a se-arate
#usiness area +ro$ the area that evelo-e or o-erates the $oel"
An auiting -rocess $ay iscover -ro#le$s ranging +ro$ ty-ing $istakes in
+or$ulas, to +una$ental errors in calculations involving conce-ts such as
value trans+er, ca-italise e3-enses an so on"
In so$e cases, s-eci+ic errors in valuation $oels, or alternative vie!-oints
o+ a +inancial structure, $ay lea to large i++erences in valuation +igures"

aluation opinions
In so$e situations, the value o+ an asset $ay #e highly uncertain"
1018
2or e3a$-le, a -ro9ect $ay involve launching a ne! -rouct !ithin a ne!
$arket, !ith a valuation #eing re&uire +or the -ur-oses o+ a sale or +or
-re-aring a #alance sheet"
In situations !here the value is highly uncertain, $a9or i++erences in asset
values $ay arise !hen an asset is re<value, or !hen an asset value is
assesse #y other -arties such as leners"
The risk o+ the #usiness su++ering a negative i$-act in these situations $ay
#e reuce #y ensuring that the +inancial an o-erational structure is not
e-enant on an asset value that is highly uncertain"
Conservative valuations
'aluing assets at conservative levels $ay reuce the risk o+ a $a9or asset
!rite<o!n"
In these cases, the assets are hel on the #alance sheet at a lo! -oint !ithin
the realistic value range"
'aluing assets at realistic levels $ay #e necessary in orer to raise e#t an
to accurately re+lect the strength o+ a #alance sheet"
=o!ever, an e3cessive valuation $ay lea to the #usiness co$$encing a
transaction that cannot #e su--orte #y the current structure, an that +ails
$i<!ay though, leaing to a large loss"
/o$$encing a -ro9ect evelo-$ent that is too large to #e +une #y the
#usiness $ay #e an e3a$-le o+ this situation"
In a case o+ +inancial istress, +uns raise +ro$ selling assets that !ere
conservatively value $ay not #e signi+icantly #elo! e3-ecte levels, an in
this case the chance o+ insolvency $ay lo!er than in a si$ilar situation in
!hich o-ti$istic valuations ha #een use"
5.32.2. /rau( & -ismanagement
5.32.2.1./rau(
2rau an $is$anage$ent are -otential risks !ithin any organisation o+
signi+icant si@e"
1011
In so$e cases, this $ay involve an e$-loyee atte$-ting to e$#e@@le $oney
+ro$ the #usiness"
This coul involve situations such as an e$-loyee !ithra!ing $oney +ro$
the #usiness accounts, or goos #eing -urchase +ro$ a #usiness associate
!ith an e$-loyee at a#ove<$arket rates"
Dhile situations such as these $ay occur at ti$es, an internal auits $ay #e
necessary to aress these risks, irect +rau $ay #e the lesser o+ t!o
-otential -ro#le$s"
The a--earance o+ +alse -ositions !ithin a #usiness o-eration $ay have a
-otentially evastating a++ect on the #usiness"
5.32.2.2.-ismanagement
In the case o+ $eiu$ si@e an large organisations, the #usiness o!ners
$ay not irectly $anage the o-erations o+ the #usiness"
Mis$anage$ent occurs !hen an iniviual or a $anage$ent tea$ $anages
the o-erations o+ a #usiness, ho!ever the $anage$ent activities are not
e++ective in o-erating an evelo-ing the #usiness"
5.32.2.2.1. #upervision
Su-ervision o+ the $anage$ent activities $ay #e -er+or$e #y the #oar o+
irectors in the case o+ a co$-any, or #y the #usiness o!ners in the case o+
other #usiness structures"
Su-ervision $ay #e #ase on revie!ing the +inancial results an other re-orts
o+ the #usiness, an revie!ing the auit re-orts"
5.32.2.2.2. /alse position situations
Although ine++ective $anage$ent activities are one -otential risk !ithin a
#usiness o-eration, a $ore serious situation can arise in !hich a +alse
a--earance o+ the #usiness is -resente"
1016
This $ay involve an entire organisation #eing +a#ricate, co$-lete !ith
assets, an organisational structure, an +inancial re-orts e3tening over
several years"
In so$e cases, the -u#lic a--earance o+ a co$-any that !as -resente to the
#oar o+ irectors through internal #rie+ings, an to investors through -u#lic
state$ents, has #een reveale to #e co$-letely +alse"
This $ay result in a #usiness that a--eare to #e in a strong +inancial
-osition, #eing reveale to #e insolvent, !ith +e! assets an large e#ts"
5.32.2.2.2.1. T.e (evelopment of a false position situation
Situations such as this o+ten #egin !ith a single iniviual !ho success+ully
evelo-e the strategy an o-eration o+ the organisation"
Aver ti$e, the iniviual $ay take irect control o+ large sections o+ the
organisation activity, an -ersonally irect o-erations an activities"
In so$e situations, usual controls an constraints $ay #e rela3e in orer to
allo! the iniviual to continue evelo-ing an e3-aning the organisationCs
activities"
2or e3a$-le, the se-aration #et!een internal areas $ay issolve, !ith the
iniviual taking irect control over several ine-enent areas"
,i$its on the si@e o+ a--rovals +or -ro9ects, asset -urchases an traing
o-erations $ay #e e3tene, or e++ectively re$ove co$-letely"
This situation $ay continue +or a -erio o+ ti$e, !ith e3-ansion -rogressing
success+ully"
=o!ever, in so$e cases, a -erio o+ -ro#le$s $ay evelo-"
2alse state$ents $ay #e $ae in an atte$-t to -revent the -ro#le$s co$ing
to light, in the e3-ectation that the -ro#le$s $ay #e a short<ter$ situation"
=o!ever, as ti$e -asses, the -u#lic -resentation o+ the situation an the
actual reality $ay iverge $ore an $ore, until eventually there are t!o
co$-letely ine-enent structures"
Ane structure is the structure that a--ears in re-orts an -resentations, !hile
the other structure is the actual reality"
1020
This situation $ay en !hen the internal o-erations colla-se, an the internal
structure is reveale to #e co$-letely i++erent to the -u#lic -resentation"
5.32.2.2.2.2. 'voi(ing false position situations
A nu$#er o+ ste-s $ay #e taken to reuce the risk o+ situations such as this
occurring"
Constraints
Although constraints $ay #e altere in line !ith the e3-ansion in si@e o+ an
activity, li$its an constraints shoul generally re$ain in line !ith the si@e o+
the o-eration"
2or e3a$-le, one co$$on arrange$ent is that an iniviual e$-loyee, or the
$anage$ent tea$, is grante authority to allocate +uns +or a -ro9ect or an
asset -urchase u- to a certain $a3i$u$ li$it"
/osts a#ove the authority li$it $ust #e -resente to the #usiness o!ners or
the #oar o+ irectors +or a--roval"
In the case o+ a success+ully e3-aning o-eration, -roceures $ay #e
strea$line an authority li$its $ay #e altere, ho!ever this shoul not
e3ten to the -oint !here an e++ective revie! o+ ecisions no longer occurs"

$eporting
Situations involving +alse -ositions $ay involve re-orting that is very late, is
lacking in etail, an contains $issing in+or$ation"
A situation such as this $ay raise issues concerning the e++ective
$anage$ent o+ the #usiness, regarless o+ issues o+ -ossi#le +alse -ositions"
Internal re-orting shoul generally #e -re-are on a regular #asis, it shoul
contain etaile an u-<to<ate in+or$ation, an it shoul #e release as soon
as is -ractical a+ter the en o+ the relevant -erio"
Dhen this oes not occur, this situation shoul generally #e investigate, an
action $ay #e taken as re&uire to ensure that accurate re-orting is carrie
out"
1021

Chinese walls
A :/hinese !all; involves a se-aration #et!een -arts o+ an organisation,
!ith each -art o-erating ine-enently"
/hinese !alls $ay #e use in situations such as stock #roking o-erations"
In this e3a$-le, a cor-orate avisory area $ay avise co$-anies on
activities that are in -rogress, !hile a traing area $ay trae #ase on
-u#licly release in+or$ation"
/o$$unication in these cases is strictly #anne"
In situations such as this, insier traing regulations -rohi#it traing
o-erations +ro$ using non<-u#lic in+or$ation in $aking traing ecisions"
Although the ter$ :/hinese !all; is not generally use in relation to
auiting, this conce-t also has signi+icant i$-lications +or the -revention o+
+alse -osition situations"
A +alse -osition is generally only -ossi#le !hen an iniviual controls
several se-arate areas, such as a traing or asset -urchasing area, a
settle$ents an a$inistration area, an an accounts -re-aration area"
I$-le$enting a /hinese<!all style o+ se-aration #et!een each $a9or area o+
an o-eration $ay signi+icantly reuce the chance o+ a +alse -osition situation
arising"
Dhere -ossi#le, the use o+ se-arate #uilings to house the various o-erations
$ay #e a signi+icant -ractical ste- in this -rocess"
Although the usual #usiness co$$unication $ay #e involve, a clear
se-aration #et!een the areas shoul #e $aintaine"
2or e3a$-le, an iniviual !ithin one area shoul not generally have the
a#ility to e$-loy sta++, allocate -ro9ects, select co$-uter syste$s an
-er+or$ other irect controls o+ the -rocesses !ithin a se-arate area"
In e++ect, co$$unication #et!een areas in these circu$stances $ay involve a
si$ilar situation to co$$unication !ith an e3ternal client"
Although this -rocess $ay not #e necessary in all areas o+ a #usiness
o-eration, a se-aration o+ this nature $ay #e -articularly i$-ortant in the
1022
case o+ $arket traing o-erations an settle$ent areas, an #et!een internal
auit areas an other areas o+ the #usiness"
Auditing
%++ective auits $ay -revent +alse -osition situations +ro$ evelo-ing in
$any circu$stances"
In cases !ere +alse -osition situations evelo- to serious levels, auit re-orts
$ay #e very late or not receive at all, #rie+ altere su$$aries o+ auit
re-orts $ay #e -resente, or serious issues $ay #e raise in auit re-orts, #ut
not aresse"
Auit re-orts shoul #e receive irectly #y the #oar o+ irectors or the
#usiness o!ners, not #y the $anage$ent tea$"
Dhere serious issues are raise, such as insu++icient recors #eing ke-t to
veri+y !hether the +igures !ere accurate or not, these issues shoul generally
#e aresse e++ectively"
Auiting o+ traing o-erations an settle$ent areas $ay #e -articularly
i$-ortant, as $a9or -ro#le$s can arise in the case o+ incorrect or inaccurate
traing recors"
,nternal audits
An internal auit area $ay #e an i$-ortant -art o+ any large organisation"
An area o+ this ty-e $ay auit iniviual areas on an occasional #asis,
revie!ing recors, re-orte +igures, an -roceures +or recoring an
re-orting in+or$ation"
An internal auit area shoul generally #e consiere to #e ine-enent o+
the rest o+ the #usiness o-eration, an re-ort irectly to the #oar or the
#usiness o!ners"
,ntervention
In so$e cases, an iniviual $ay evelo- a high -ro+ile !ithin an
organisation, an other -arts o+ the organisation $ay have i++iculty in
conucting auits, or revie!ing ecisions, ue to the -ro+ile hel #y the
iniviual"
1023
=o!ever, the assets o+ the #usiness re$ain the -ro-erty o+ the #usiness
o!ners or shareholers, an the e#ts o+ the #usiness are also the
res-onsi#ility o+ the #usiness"
In the case o+ so$e large organisations, a $anage$ent tea$ $ay eter$ine
the irection o+ the #usiness, !ith the #oar o+ irectors -er+or$ing a
su-ervisory role, to ensure that $a9or -ro#le$s are not evelo-ing, an to
take actions that irectly a++ect the shareholers, such as res-oning to
takeover o++ers"
In cases !here re-orting is not ae&uate, !here auit re-orts raise serious
issues, an so on, the #oar $ay intervene in the o-erations o+ the
organisation i+ it is necessary to ensure that the -ro#le$s are resolve"
The se-aration o+ control that can so$eti$es occur in these cases shoul not
generally e3ten to a $e$#er o+ a $anage$ent tea$ having authority to
-revent an internal auit area +ro$ -er+or$ing auit activities, or to -revent
en&uiries #eing $ae #y #oar $e$#ers to eter$ine the internal o-erations
o+ the #usiness"

5.32.2.2.2.3. E)ternal revie5s
5ro#le$s $ay also arise in cases !here a +alse -osition is -resente #y the
#usiness o!ners or the #oar o+ irectors the$selves"
This situation $ay occur in the case o+ -rivate #usiness structures, although it
is not co$$on in large organisations or liste co$-anies"
/reitors an shareholers holing su#stantial -ositions in a #usiness $ay
re&uest that ine-enent auits #e conucte, or in the case o+ s$aller
enter-rises, $ay check recors an o-erations -ersonally"
#.!!. 6iscellaneous business issues
5.33.1. /ree items
Dhen the la#el :+ree; is associate !ith ite$s +or sale, this $ay so$eti$es
#e associate !ith strong interest +ro$ custo$ers"
1020
=o!ever, as a custo$er, a #usiness shoul #e a!are o+ the +act that a :+ree;
ite$ $ay have various co$-onents in the #usiness environ$ent"
2or e3a$-le, t!o #usinesses $ay have avertise a -ackage o+ -roucts in
the +ollo!ing !ay"
Business A Business B
5rouct A 100 10
5rouct B +ree 20
Total /ost 100 100
In this situation, #usiness A has inclue a :+ree; -rouct !ith their sale o+
-rouct A, !hile #usiness B has not"
=o!ever, the total cost o+ -urchasing the t!o -roucts is sa$e, !hether they
are -urchase +ro$ #usiness A or #usiness B"
In +act, ha the -ricing #een i++erent, the cost o+ -urchasing the -ackage
+ro$ the #usiness that inclue the +ree gi+t coul actually have #een higher
than the cost o+ -urchasing the -ackage +ro$ the #usiness than i not
inclue the +ree ite$
As a #uyer, the relevant issue is the total value o+ ite$s that are receive,
co$-are !ith the total cost -ai"
,a#els o+ :+ree; are irrelevant in these situations"
Although the ter$ is technically correct, a $ore accurate -hrase $ay #e
:inclue !ithin the stanar -rice; or :at no aitional charge;"
2ree ite$s $ay re-resent a genuine iscount to the stanar -rice in t!o
circu$stances"
A co$$on -ro$otion techni&ue is to -urchase a set o+ ite$s, an inclue
these ite$s +or no aitional charge !ith the stanar -rouct, +or a li$ite
-erio o+ ti$e"
This $ay -rovie a te$-orary #oost in sales, clear inventory, an raise the
-ro+ile o+ the -rouct"
102*
In this case, a genuine iscount has #een inclue +or the li$ite -erio, as
the stanar -rice o+ the -rouct has #een $aintaine"
2ree ite$s $ay also involve issues such as interest<+ree +inance, !here the
ite$ is availa#le +or the sa$e -rice !ith or !ithout the interest<+ree
+inancing"
In this case, the #usiness is e++ectively o++ering to sell the ite$ +or t!o
i++erent -rices, !ith the interest<+ree a--roaching involving a lo!er total
cost to the #uyer than a irect sale"
=o!ever, any ite$s that are inclue +or +ree on a -er$anent #asis shoul
generally #e consiere a -art o+ the stanar -rouct -ackage, an
co$-are irectly !ith alternatives availa#le +ro$ other #usinesses"
#.!". Economic an( in(ustry structure
The +ollo!ing section escri#es so$e structures an issues relating to
econo$ies an inustries, as a--lica#le at the ti$e o+ !riting"
%cono$ies an inustries $ay change su#stantially over ti$e"
=o!ever this section $ay highlight so$e o+ the structures that a--ear +ro$
ti$e to ti$e, an so$e o+ the issues that $ay a--ly"
(>> check etails o+ iniviual econo$ies an +igures)
5.34.1. T.e struture of some eonomies.
5.34.1.1.T.e 7nite( #tates
The Hnite States hols the largest iniviual econo$y in the !orl,
generating a--ro3i$ately ??L o+ !orl econo$ic -rouction"
(>>check econo$ic -ercentage)"
The HS stock $arket co$-rises roughly hal+ the ca-italisation o+ glo#al
stock $arkets"
The HS econo$y is #roaly #ase, !ith a $i3 o+ -ri$ary -rouction such as
+ar$ing, $anu+acturing, an service inustries"
102)
7e+ence e&ui-$ent -rouction is a signi+icant inustry in the HS, an also in
Britain (>>check)"
The -har$aceuticals inustry is also a signi+icant inustry !ithin the HS, an
inclues a nu$#er o+ large #usiness o-erations"
These inustries $ay have a s$all -resence !ithin $any s$aller econo$ies"
5.34.1.2.Britain
The British econo$y is also a #roaly #ase econo$y"
Many British organisations o-erate in various regions o+ the !orl, re+lecting
the colonial history o+ British activity"
The British econo$y involves a high level o+ $anu+acturing activity, an
Britain i$-orts ra! $aterials an e3-orts $anu+acture ite$s"
British +ir$s have a signi+icant involve$ent in heavy engineering such as
shi- #uiling an co$$ercial construction"
A large nu$#er o+ construction engineering -ro9ects, such as co$$ercial
o++ice #uiling evelo-$ents uring the construction #oo$ in Asia uring
the 1610Cs (>>check ecae) have #een esigne #y British engineers"
5.34.1.3.Europe
%uro-e co$-rises a signi+icant -ro-ortion o+ glo#al econo$ic activity"
The (er$an econo$y is -articularly signi+icant"
The (er$an econo$y inclues a signi+icant $anu+acturing sector"
Inustries !ithin (er$an are generally heavily regulate"
In+lation is consiere a $a9or issue, re+lecting the e3tre$e in+lation rates in
(er$any in the 1620Cs (>> check -erio)"
The Bunes#ank (>> check s-elling) central #ank in (er$any $anages
interest rates !ith a $a9or vie! to the risk o+ in+lation evelo-ing"
1028
2rance is also a $a9or econo$y !ithin the %uro-ean region"
Inustry !ithin %astern %uro-e an regions o+ the +or$er Soviet Hnion is
-oorly evelo-e, !ith $any regions #eing largely agricultural +ar$ing
areas, !ith little inustrial -rouction +acilities"
5.34.1.4.>apan
The Fa-anese econo$y re-resents a $a9or -art o+ !orl econo$ic -rouction
(>> eheck +igures)"
The Fa-anese econo$y is heavily orientate to!ars $anu+acturing"
This inclues vehicles, heavy engineering, consu$er electrical goos, an
co$$ercial #uiling construction"
Fa-an has very +e! natural resources, an the Fa-anese econo$y i$-orts a
large nu$#er o+ $aterials, !hile e3-orting $anu+acture goos"
The Fa-anese econo$y e3-ane continuously over the +i+ty year -erio
+ollo!ing the secon !orl !ar to the late 1610Cs"
Aver the 1660Cs, the Fa-anese stock $arket ecline steaily to loose a
su#stantial -art o+ its value +ro$ the -eak in the late 1610Cs"
The Fa-anese econo$ic syste$ has a structure that is su-er+icially Destern in
o-eration"
This inclues a large stock $arket, traitional Destern cor-orate structures,
an a #anking syste$ that is si$ilar to the syste$s o-erating in $any
Destern econo$ies"
=o!ever, Fa-anese #usiness -ractices $ay #e signi+icantly i++erent +ro$
-ractices in other econo$ies"
2or e3a$-le, $any Fa-anese #usinesses are grou-e into #roa associations
kno!n as (>> check s-elling), !hich trae !ith each other in -re+erence to
traing !ith custo$ers in the #roa econo$y"
/reit issues $ay #e consiere seconary to on<going #usiness associations
in so$e circu$stances"
1021
5.34.1.5.+.ina
/hina is a huge region #oth geogra-hically an in ter$s o+ -o-ulation, !ith
over one #illion -eo-le living as -art o+ the /hinese re-u#lic"
/hina o-erates uner a co$$unist syste$ o+ govern$ent"
Hner the co$$unist syste$, resources are allocate #y the state, rather than
#eing o!ne #y iniviuals an trae #et!een iniviuals"
/hina is largely a rural econo$y, !ith $any areas having little in the !ay o+
inustrial $anu+acturing +acilities"
=o!ever, there are several cities !ithin /hina !ith sell evelo-e econo$ies
an signi+icant co$$ercial activity in a si$ilar !ay to that !hich $ay occur
in Destern cities"
Business has a strong traition !ithin /hina, an #usiness activity e3tens
#ack several thousan years"
/hina an Asian regions in general $ay have a traitional outlook to!ars
luck an goo +ortune, in contrast to the scienti+ic rationalist vie! o+ the
!orl that $ay #e -revalent !ithin Destern societies"
5.34.1.!.+ana(a
/anaa has a si$ilar -o-ulation to Australia an the /anaian econo$y has
a nu$#er o+ si$ilarities to the Australian econo$y"
Mining is a signi+icant section o+ the /anaian econo$y"
South A+rica also has a signi+icant $ining sector"
The $oern -o-ulations o+ /anaa, South A+rica an Australian all
e3-aning ra-ily !ith (ol !as iscovere in large &uantities"
5.34.1.7.T.e -i((le East
Ail is the $a9or e3-ort o+ the Mile %astern region"
1026
This region su--lies a large -ro-ortion o+ the !orlCs su--ly o+ oil"
In turn, oil is a $a9or in-ut to the evelo-e econo$ies"
Ail is use in the -rouction o+ +uel, incluing iesel +uel, -etrol, an
aviation +uel"
Ail is also the ra! $aterial that use +or the $anu+acture o+ -lastic"
Manu+acturing in the Mile %astern region is largely conucte #y s$all<
scale o-erations"
,arge inustrial -lants are less co$$on in the Mile %ast than in the
econo$ies o+ the Dest"
=o!ever, signi+icant technology $ay #e evelo-e an use !ithin so$e o+
these o-erations, although large<scale inustrial -rouction such as $otor
vehicles is not co$$on !ithin this region"
5.34.1.8.'ustralia
(conom*
The Australian econo$y is a #roaly #ase econo$y, !ith a $i3 o+
$anu+acturing, -ri$ary -rouction an services"
Mining is a +eature o+ the Australian econo$y an +or$s a signi+icant
-ro-ortion o+ activity"
Mining is a s$all +eature o+ $ost econo$ies, !ith several iniviual
countries such as /anaa also having signi+icant $ining o-erations"
Services are a signi+icant -art o+ the Australian econo$y"
2inancial services, incluing #anking an insurance organisations, co$-rise
over a &uarter o+ the stock $arket ca-italisation (>> check +igures)"
Australia conucts signi+icant -ri$ary -rouction activities"
This inclues e3-orting large &uantities o+ !ool, !heat, coal, iron ore an
other #ulk co$$oities, in aition to $anu+acture -roucts, services an
technology"
1030
,iste -ro-erty trusts are a +eature o+ the Australian stock $arket"
These vehicles +or$ aroun *L (>> check -ercentages) o+ the $arket, !hich
is signi+icantly higher than the -ro-ortion in $ost other evelo-e $arkets"
,iste -ro-erty trusts are invest$ent vehicles that -ool invest$ent ca-ital
an -urchase large co$$ercial #uilings an inustrial co$-le3es"
5ro-erties o+ this ty-e are generally o!ne irectly #y various organisations
in $ost other Destern econo$ies, such as retire$ent +uns an asset
$anage$ent +uns"
Political s*stem
The -olitical syste$ in Australia is #ase on e$ocratically electe
govern$ents"
5arlia$ent -asses la!s, raises ta3es, an allocates +uns"
Al$ost hal+ the econo$y is #ase on organisations an activities +une
+ro$ govern$ent revenues"
This -ro-ortion is si$ilar to the -ro-ortion o+ the -u#lic syste$ !ithin other
evelo-e econo$ies (>> check etails)
Legal s*stem
The legal syste$ is #ase on a continuation o+ the legal syste$ evelo-e
through the last +e! hunre years +ro$ %nglish court 9uge$ents"
The legal syste$ is ine-enent o+ the -olitical syste$"
,egal 9uge$ents are #ase on la!s -asse #y 5arlia$ent, an +ro$ the long
history o+ legal 9uge$ents that have -rouce the -rinci-les o+ contract la!
an other legal conce-ts"
(conomic s*stem
The Australian econo$ic syste$ is a ca-italist syste$, !hich recognises the
conce-t o+ iniviual -ro-erty rights"
Iniviuals $ay o!n -ro-erty, an $ay #uy an sell ite$s"
1031
=o!ever, a signi+icant -ro-ortion o+ assets an structures are also o!ne
through the -u#lic sector, !hich o-erates uner a si$ilar conce-t to the
co$$unist syste$, !here resources are allocate #y a central authority,
rather than #eing trae #et!een -arties"
Capital markets
Australia has a strong #anking syste$ an a !ell evelo-e stock $arket"
7ue to the large volu$e o+ agricultural -rouction, the +utures $arket in
Australia is !ell evelo-e an the Syney 2utures %3change conucts a
signi+icant -ro-ortion o+ +utures traing activity !ithin the Asia<5aci+ic
region"
2unraising through -u#lic e&uity raisings is si$ilar in o-eration to +uning
activity in other evelo-e econo$ies, although the venture ca-ital $arket in
Australia are not as !ell evelo-e as in so$e o+ the larger econo$ies"
5.34.2. 4n(ustr$ struture
Hnless other!ise inicate, re+erences to the structure o+ inustries re+er to
the Australian econo$y"
=o!ever, $any inustries have a si$ilar structure an o-eration in the other
evelo-e econo$ies o+ the Destern !orl"
5.34.2.1.3rimar$ pro(ution
The -ri$ary -rouction sector o+ the econo$y is a relatively s$all -art o+ the
econo$y in -ercentage ter$s, as is the case in $ost evelo-e econo$ies"
=o!ever, -ri$ary -rouction activities +or$ a $a9or -art o+ e3-orting
activity, an +or$ a larger -art o+ the Australian econo$y that is the case in
econo$ies that have +e! natural resources, such as Fa-an"
5ri$ary -rouction is $ainly organise as sole enter-rises an +a$ily
o-erations"
1032
5.34.2.2.-ining
Mining is a ca-ital intensive inustry, re&uiring large ite$s o+ e&ui-$ent to
-er+or$ $ining o-erations"
Mining e3-loration is also ca-ital intensive, !ith large su$s o+ ca-ital #eing
re&uire to locate an evelo- ne! $ines"
The out-ut -roucts o+ $ining are co$$oities that generally trae in glo#al
$arkets, !ith -rices #eing volatile an #eing eter$ine #y su--ly an
e$an !ithin the $arket"
An e3ce-tion to this $ay #e #ulk co$$oities, such as coal an iron ore,
!hich $ay #e sol through long<ter$ custo$er agree$ents"
A-eration o+ a $ining activity $ay involve scheuling -rouction an
-lanning the e3traction o+ the ore #oy"
/o$-le3 $oels $ay #e evelo-e o+ the esti$ate structure o+ the
unergroun ore, #ase on geological +or$ations"
A success+ul $ine o-eration $ay involve locating an ore #oy !ith a high
enough grae o+ the co$$oity co$-are to the surrouning ore, to ena#le
the co$$oity to #e e3tracte at a cost that is lo! enough to result in a
-ro+ita#le sale at $arket -rices"
Market -rices vary !iely over ti$e, an so$e $ines are close +or -erios
o+ ti$e uring sustaine lo! -rices, an reo-ene !hen -rices rise"
Mining o-erations once co$-rise 10L (>> checking ti$ing an +igures) o+
the stock $arket, although !ith technology i$-rove$ents an lo!er costs
this has ecline over a long -erio to #e aroun 1*L at the ti$e o+ !riting"
5.34.2.2.1. Bul6 mining
Australian $ining o-erations +or$ a signi+icant -art o+ the econo$y, !ith
Australia su--lying a large -ro-ortion o+ the !orlCs su--ly o+ a range o+
i++erent co$$oities (>>check etails)
Bulk $ining inclues coal, iron ore, an #au3ite +or -roucing alu$iniu$"
Bulk $ining is -er+or$e #y several large $ining co$-anies"
1033
Most o+ the -rouction is e3-orte to various regions, !ith Fa-anese steel
$ills #eing a $a9or custo$er o+ iron ore (>>check)"
Ail an gas is also -rouce #y several large organisations"
Ail an gas -rouction is a highly ca-ital intensive inustry, !ith large su$s
o+ ca-ital #eing re&uire to esta#lish oil rilling -lat+or$s"
5.34.2.2.2. 3reious metals
5recious $etals such as gol, silver an -latinu$ are -rouce +ro$ $ines
!ithin Australia an aroun the !orl"
Mineral sans are also $ine to e3tract rare $inerals +ro$ $ineral sans"
,arge $ining co$-anies $ay o-erate a nu$#er o+ $ines, !hile a range o+
s$all o-erations $ay conuct e3-loration activities or o-erate a s$all
nu$#er o+ $ines"
Start<u- o-erations $ay #e co$$on !ithin the $ining inustry, -articularly
uring ti$es o+ high -rices +or -articular $ining co$$oities"
A su$ o+ ca-ital $ay #e raise +ro$ investors, e3-loration $ay #e
conucte, an ore #oy $ay #e locate an $ining $ay co$$ence"
These o-erations $ay #e +or$e #y a nu$#er o+ associate -eo-le, rather
than as a sole enter-rise"
The cash #urn rate o+ these o-erations $ay #e high, an an e3-loration
co$-any $ay raise aitional ca-ital every +e! years, or in so$e cases $ore
+re&uently"
5.34.2.3.Ban6ing
Banking in Australia is highly concentrate, !ith the +our $a9or #anks
+or$ing the #ulk o+ #anking o-erations, !ith a range o+ s$aller #anks also
o-erating"
This is in contrast to $any other countries"
1030
In the HS, +or e3a$-le, until recently la!s -rohi#ite #anks +ro$ o-erating
across $ulti-le states, an the #anking inustry in the A$erica is highly
+rag$ente"
Banking $ay involve t!o &uite se-arate #usinesses"
-ransaction "anking
Transaction #anking $ay involve the ay<to<ay o-erations o+ e-osits,
che&ue clearing, an account trans+ers"
Transaction #anking is a service #usiness"
Banks $ay o-erate !ith a large loss in transaction #anking, !hich is
su#siise #y the other -art o+ the #anking o-erations, involving loans an
e-osits"
Banking is a la#our<intensive inustry, !ith large nu$#ers o+ sta++ #eing
e$-loye in #ranches an a$inistration areas"
Banking is graually changing +ro$ a la#our<intensive inustry to a
technology<intensive inustry"
5ay$ents through ATMCs, %2T5AS an internet trans+ers no! $ake u- a
signi+icant -ro-ortion o+ #anking transactions, !ith less than 20L o+
transactions no! #eing -ersonally conucte in a #ranch" (>> check etails)
Technology $ay also #e involve in -rocesses such as auto$ate che&ue
scanning, $ailing o+ letters an state$ents, an so +orth"
Asset "anking
Asset #anking involves loans an $a9or e-osits"
Asset #anking is a #alance<sheet #usiness"
The #ankCs ca-ital su--orts a large s-rea o+ leners an #orro!ers"
The i++erence in interest charge on loans, an interest -ai on e-osits,
+or$s the return on the shareholerCs +uns"
The $a9or activity involve in this -rocess $ay involve the creit -rocessing
o+ loan a--lications, an a$inistrative -rocessing o+ e-osits"
103*
Credit management
/reit $anage$ent $ay #e a $a9or issue in #anking, !ith the ai$ o+ creit
assess$ent #eing to acce-t a large -ro-ortion o+ loan a--lications, !hile also
re9ecting loan a--lications than $ay #e likely to result in e+aults on
-ay$ents an losses"

/reit $anage$ent uring $ost -erios o+ recent history has #een largely
success+ul, !ith the a$ounts o+ ca-ital lost to #a e#ts in $any #anks #eing
s$all in relation to the volu$e o+ loans on issue"
A $a9or risk in #anking $ay involve the -ossi#ility o+ a large increase in
loan e+aults, either through -oor lening an creit $anage$ent, or through
a $a9or recession leaing to a large nu$#er o+ insolvencies an li&uiations"
Banks $aintain shareholerCs ca-ital that is e&ual to aroun 1L o+ the total
loans on issue (>>check)"
This ca-ital -rovies the #u++er to su--ort the e+aults on loans that $ay
occur uring the #anking -rocess"
7uring the late 1610Cs +or e3a$-le, #anks !ere involve in a ra-i e3-ansion
an large loans !ere $ae +or evelo-$ent activities"
7uring the $a9or recession o+ the early 1660Cs, so$e $a9or #anks ca$e close
to insolvency"
5.34.2.4.4nsurane
5.34.2.4.1. 1eneral 4nsurane
(eneral insurance is a no! a co$$oity #usiness"
A co$$oity is a -rouct that is sol in large volu$es, an is -rouce #y a
range o+ i++erent #usiness"
%3a$-les o+ co$$oities $ay inclue agricultural co$$oities, $ining
co$$oities, stanarise co$-uter har!are, an general insurance"
In these cases, si$ilar -roucts $ay #e o++ere #y $ulti-le #usinesses, an
-rice $ay #e a $a9or +actor in a -urchase ecision"
103)
Dithin co$$oity inustries, econo$ies o+ scale an e++icient -rouction or
service elivery $ay #e $a9or +actors in eter$ining the success o+ a
#usiness o-eration"
(eneral insurance !as once a la#our<intensive inustry, !ith large a$ounts
o+ $anual a$inistration an -rocessing o+ -a-er ocu$ents"
7uring the 1610Cs (>>check -erio), co$-uter -rocessing o+ insurance
a$inistration !as i$-le$ente to a greater e3tent than -revious usage"
A cycle o+ inustry rationalisation #egan, !ith large o-erations #eco$ing
larger, s-reaing +i3e costs across a larger nu$#er o+ transactions, an
resulting in a lo!er cost -er transaction"
Rates !ere reuce to #elo! the cost o+ -rouction to #uil custo$er
volu$es an to evelo- sustaina#le o-erations !ith larger volu$es an lo!er
costs"
2ollo!ing several years o+ #elo!<cost -ricing, an a nu$#er o+ $ergers,
co$-any +ailures an !ithra!als +ro$ the inustry, several large o-erators
e$erge"
(eneral insurance $ay involve t!o o-erationsB a$inistration an
uner!riting"
The uner!riting o-eration assesses the insurance risk an sets the -re$iu$
rate, an the clai$s area -rocesses clai$s against the insurance -olicies"
(eneral insurance is e++ectively an a$inistration #usiness, selling
co$$oity -roucts in high volu$es"
7ue to the +act that there are +e! #arriers to entry an that $any
organisations consier esta#lishing insurance o-erations, $argins a sli$ an
-ro+ita#ility is not high !ithin this inustry"
5.34.2.4.2. 8ife insurane
,i+e insurance co$-anies in Australia, an also in other -arts o+ the !orl,
-articularly in Britain an %uro-e (>>check), $ay trace their history #ack
over $ore than a century"
1038
In so$e cases, li+e insurance o-erations #egan as co<o-erative societies, !ith
-oole +uns #eing use as a co$#ination o+ a savings -lan an risk<#ase
insurance"
These +uns continually e3-ane over ti$e, an there are no! so$e very
large li+e insurance organisations in o-eration"
/utual funds
A :$utual; insurance organisation is one in !hich the custo$ers are also
e++ectively the shareholers o+ the o-eration"
This is the nature o+ a co<o-erative society"
This structure !as once co$$on +or savings an insurance organisations"
Although this arrange$ent $ay a--ear to #e $ore attractive to a custo$er
than a co$$ercial o-eration, !here a -ro-ortion o+ -rouct -rices $ay #e
retaine as net -ro+it an istri#ute to shareholers, in -ractice the o--osite
situation $ay o+ten occur"
More e++icient o-erations an structures !ithin co$$ercial enter-rises, in
co$-arison to $utual societies, $ay resulte in lo!er -rices #eing charge
#y co$$ercial enter-rises than $utual +uns, es-ite the -ro+it<$aking
nature o+ the enter-rise"
Also, an iniviual $ay #e #oth a custo$er an a shareholer o+ a
co$$ercial enter-rise"
In this case, ho!ever, the relationshi-s are clearly se-arate, an an
iniviual $ay chose to #e a custo$er, a shareholer, #oth, or neither"
Most large $utual li+e insurance societies converte to co$$ercial
enter-rises uring the late t!entieth century"
Bundled & un"undled products
In the -ast, insurance -roucts !ere o+ten #unle -roucts, an $ay have
inclue a saving -lan, risk<#ase li+e insurance, invest$ent, an other
+eatures such as te$-orary !ithra!al through a loan"
These -roucts !ere generally co$-le3 to a$inister an ha high internal
+ess e$#ee !ithin the structure"
1031
Dithra! -enalties !ere also high, !ith -enalties +or early !ithra!al
a--lying +or u- to 10 or 1* years a+ter the co$$ence$ent o+ the -olicy"
These -roucts graually lost +avour to ne! -roucts that !ere evelo-e
uring the 1610Cs"
A $ore co$$on a--roach $ay no! involve risk<#ase insurance -olicies,
an se-arate invest$ent +uns +or asset holings"
Distri"ution
,i+e insurance !as originally sol oor<to<oor on a co$$ission #asis"
=o!ever, li+e insurance $ay no! #e $ore co$$only o++ere through
istri#ution channels such as #anks an +inancial avisory services, an
irectly +ro$ the custo$er to the li+e insurance co$-any itsel+"
Activities
,i+e insurance $ay involve t!o $a9or activitiesB uner!riting o+ risk<#ase
insurance, an invest$ent $anage$ent"
Risk<#ase insurance $ay #e o++ere as a stan<alone -rouct, or $ay #e a
co$-onent o+ a #unle -rouct or a -oole savings sche$e"
Risk<#ase li+e insurance $ay +ollo! the sa$e #asic structure as other +or$s
o+ insurance"
A #u++er o+ ca-ital $ay #e ke-t to $eet clai$s"
Risks $ay #e assesse, -re$iu$s $ay #e -ai, an clai$s $ay #e -ai as
they occur"
Invest$ent $anage$ent $ay involve investing +uns in shares, -ro-erty, an
+i3e interest securities such as govern$ent #ons"
Invest$ent $anage$ent $ay #e use !ithin li+e insurance co$-anies to
invest the reserves that are hel +or $eeting clai$s, to $anage invest$ents in
+uns that are selecte #y custo$ers, an to $anage +uns hel !ithin -oole
savings sche$es or #unle insurance -roucts"
1036
,i+e insurance, as !ith general insurance, $ay have a large a$inistration
co$-onent"
=o!ever, li+e insurance is still a la#our<intensive #usiness, an it is -ossi#le
that this inustry $ay +ollo! a si$ilar -ath to the general insurance inustry,
an #eco$e heavily co$-uterise !ith high volu$e a$inistration services
#eing use"
,arge $ain+ra$e co$-uter syste$s are heavily use in insurance"
The #anking an insurance inustries !ere a$ong the +irst $a9or uses o+
co$-uters"
=o!ever, these so+t!are syste$s $ay #e e3tre$ely co$-le3, ue to the
co$-le3 nature o+ the -roucts"
At -resent, these o-erations $ay not #e suita#le +or the si$-licity an
e++iciency o+ the high volu$e a$inistration services that $ay o-erate in
other inustries such as -ay$ents -rocessing"
aluation
'aluation o+ li+e insurance co$-anies is a s-ecialise activity"
,i+e insurance has its o!n -ro+ession, #eing the actuarial -ro+ession, !hich
-er+or$s statistical an +inancial calculations involving insurance
-ro#a#ilities an long<ter$ cash +lo!s"
,i+e insurance co$-anies are value using an :e$#ee value;, !hich is
e++ectively a net<-resent<value calculation o+ the +uture inco$e strea$ +or the
-rouct accounts that are currently o-erating" (>> check)
Solvenc*
Solvency $ay #e a $a9or issue !ith #oth li+e insurance an #anking
o-erations"
Su++icient ca-ital $ay #e neee to $eet -ossi#le losses ue to large clai$s
or loan e+aults, !hile e3cess ca-ital $ay reuce shareholer returns"
Insurance co$-anies an #anks $ay atte$-t to raise aitional ca-ital uring
-erios o+ -oor solvency"
1000
=o!ever, i+ the organisation !aits until serious -ro#le$s have alreay
occurre an there is a serious risk that the organisation $ay #eco$e
insolvent, in so$e cases aitional ca-ital $ay not #e a#le to #e raise, ue
to the high risk that investors $ay loose the $oney that is investe uring the
ca-ital raising"
,i+e insurance is regulate on a su-ervisory #asis #y a govern$ent authority"
Banking is also regulate in this !ay, ho!ever in the case o+ #anking there
are also s-eci+ic ca-ital re&uire$ents +or #anking o-erations"
5.34.2.5.2ealt.are
The health inustry is a signi+icant section o+ the Australian econo$y, as it is
in $ost econo$ies o+ the Destern !orl"
=ealth an eucation are t!o $a9or areas o+ govern$ent e3-eniture, !ith
other $a9or areas #eing e+ence an a !ie range o+ other -rogra$s an
e3-enses"
The health syste$ involves -u#lic hos-itals, -rivate hos-itals, health +uns,
the govern$ent health insurance sche$e, octors an s-ecialists in -rivate
-ractice, an a !ie range o+ other areas such as -athology la#oratories"
=ealthcare is a highly regulate inustry"
Issues such as +ee rates, access to various +acilities, -roceures an a--roval
+or various activities are controlle in $any cases through govern$ent
regulations"
Meical -ractices $ay #e conucte as sole enter-rises or -artnershi-s in
$any cases"
Traitional #usiness o-erations $ay involve -rivate hos-itals, an so$e
other +acilities such as raiology o-erations an -athology la#oratories"
In the case o+ heath care, $any in-ut an out-ut costs $ay #e +i3e, an the
arrange$ents +or +uning !ith health +uns an the govern$ent health
syste$ $ay #e co$-le3"
1001
5.34.2.!.'sset ve.iles
Asset vehicles inclue trusts an co$-anies !hose $a9or role is si$-ly to
contain a -hysical asset"
This inclues -ro-erty trusts, !hich o!n large co$$ercial an inustrial
-ro-erties, an in+rastructure vehicles, !hich o!n assets such as toll roas
an air-orts"
2ro$ the -ers-ective o+ an investor, these assets $ay #e si$ilar to a +i3e<
interest #on, !ith a highly sta#le +uture cash +lo!"
Asset vehicles $ay also have a steay ca-ital gro!th"
These vehicles $ay trae !ith sta#le -rices an lo! volatility, !ith the -rice
largely #eing eter$ine on a yiel #asis, !ith the inco$e yiel #eing
co$-ara#le to #ank e-osits an govern$ent #ons"
,nfrastructure trusts
In+rastructure trusts $ay #e esta#lishe on a single<+ee #asis, or !ith an on<
going +ee to the -arty !ho create the asset vehicle"
/reating the asset vehicle $ay involve so$e o+ the +ollo!ing activities"
Arranging a +un raising"
5urchasing the assets"
%sta#lishing an invest$ent a$inistration o-eration, to hanle
issues such as $aintenance, inco$e collection, an istri#utions to
unit holers or share holers"
Structures o+ this ty-e $ay #e create #y an invest$ent #ank"

Propert* trusts
In the case o+ asset vehicles such as -ro-erty trusts, t!o se-arate issues $ay
#e involve"

1002
This $ay inclue the $anage$ent o+ the -ro-erty itsel+, !hich $ay involve
locating an co$$unicating !ith tenants, arranging leases, arranging
$aintenance an so on"
Also, $anaging a -ro-erty trust $ay involve the invest$ent $anage$ent o+
the assets"
This $ay involve selecting an a--ro-riate $i3 o+ -ro-erties !ithin the
-ort+olio, #uying an selling -ro-erties, an arranging re+ur#ish$ents, !ith a
vie! to i$-roving the ca-ital gro!th o+ the -ort+olio"
/reating an $anaging an asset vehicle is a service #usiness"
The -ro-erty trust sector is a signi+icant sector in the Australian stock $arket,
!ith a#out *L o+ the $arket #eing $ae u- o+ -ro-erty trusts"
This is a $uch larger -ro-ortion than in $any other countries, in !hich the
list -ro-erty trust sector $ay #e &uite s$all"
5.34.2.7.Biote.nolog$
Biotechnology involves the evelo-$ent o+ $eical technology +or -ur-oses
such as iagnostic tools to ienti+y the -resence o+ iseases"
The Biotechnology sector in Australia co$-rises a range o+ s$all
organisations"
This sector $ay o-erate in a si$ilar !ay to $ining e3-loration, an the
esta#lish$ent o+ so+t!are co$-anies uring the Internet #oo$, !ith s$all
co$-anies raising ca-ital to evelo- ne! -roucts, an o+ten o-erating !ith
negative cash +lo! an high #urn rates"
5.34.2.8.3.armaeutials
The -har$aceutical inustry involves the evelo-$ent an -rouction o+
$eical rugs an other -har$aceutical -roucts"
The -har$aceutical inustry oes not have a signi+icant -resence in
Australia, although this $ay #e a signi+icant inustry !orl<!ie"
The evelo-$ent o+ ne! rugs $ay #e an e3tre$ely e3-ensive -rocess"
1003
7rug evelo-$ent $ay re&uire large su$s o+ ca-ital"
Thousans o+ -otential co$-ouns $ay #e investigate through a long series
o+ trials an tests, an the evelo-$ent o+ a single success+ul rug $ay take
over a ecae"
The inco$e +ro$ rug -rouction $ay #eco$e a long<ter$ inco$e strea$ to
the co$-any, !ith the cost o+ -rouction #eing lo! in co$-arison to the
evelo-$ent costs"
The evelo-$ent o+ ne! rugs is +una$entally a -ro9ect<#ase activity,
!ith a -erio o+ high ca-ital e3-enses uring the evelo-$ent -hase, an a
long<ter$ inco$e strea$ +ro$ sales in the event o+ an e++ective co$-oun
#eing evelo-e"
5.34.2.9.Teleommuniations
The teleco$$unications sector is a signi+icant section o+ the econo$y, #oth
in Australia an overseas"
This inclues tele-hone services, $o#ile tele-hone co$$unication, an ata
services"
Teleco$$unications $ay involve co$-le3 technology, ho!ever
teleco$$unications this is largely a ca-ital<intensive inustry, rather than a
technology<intensive inustry"
The teleco$$unications inustry is o$inate #y several large
organisations"
Teleco$$unications is a gro!th inustry, -articularly in ter$s o+ ata
services"
,arge ca-ital invest$ents $ay #e re&uire to install an $aintain e&ui-$ent
an +acilities such as tele-hone lines, e3changes, ca#le services an $o#ile
co$$unication +acilities"
=o!ever, varia#le o-erating costs $ay #e lo!"
2acilities $ay #e largely auto$ate, an there $ay #e +e! ra! $aterials or
other costs associate !ith the actual use o+ tele-hone services"
1000
The inco$e +ro$ services $ay #e use to o++set the +i3e costs o+ installing
an $aintaining e&ui-$ent"
This inustry also inclues a nu$#er o+ s$all organisations that o not
construct or o!n +acilities, #ut -urchase o-erating ti$e in #ulk +ro$ the
$a9or o-erators, an then -rovie services irectly to custo$ers"
These o-erations $ay #e istri#ution an service #usinesses"
5.34.2.1". ,etail
Retailing +or$s a signi+icant -ro-ortion o+ econo$ic activity"
Retail o-erations $ay vary !iely +ro$ s$all o-erations conucte as sole
enter-rises, to large chains o+ stores an large organisations o-erating a range
o+ i++erent retail activities"
Retailing $ay involve issues o+ inventory an stock $anage$ent, selection
o+ -roucts to carry, avertising, an the location o+ +acilities"
Sales patterns
So$e retailing o-erations are seasonal, !ith sales occurring at certain ti$es
o+ the year"
This $ay #e calenar e-enant, such as 7ece$#er retail sales, or !eather<
e-enant, such as su$$er or !inter retailing activities"
Ather retail o-erations $ay #e cyclical, such as the retailing o+ consu$er
ura#le -roucts such as !hitegoos"
These o-erations $ay e3-erience sales levels that $ay rise an +all !ith the
general level o+ econo$ic activity"
In cases involving consu$er sta-le goos such as +oo retailing, sales $ay
not vary greatly e-ening on econo$ic conitions or seasonal e++ects"
/argins
Barriers to entry in the retailing inustry are lo!, an retailing is a highly
co$-etitive inustry"
100*
Many retail o-erations o-erate !ith lo! $argins an li$ite -ro+ita#ility"
Su-er$arket chains are o-erate #y several large organisations, ue to the
econo$ies o+ scale that $ay #e -ossi#le through centralise #uying an
s-reaing +i3e costs such as avertising across a large nu$#er o+
transactions"
Su-er$arkets $ay o-erate !ith $argins o+ only a +e! -ercent o+ sales"
2ashion #outi&ues an s-ecialty stores $ay #e at the other en o+ the
s-ectru$, !ith high $argins on iniviual ite$s, an a lo! volu$es o+ sales"
+ranchise & compan* chains
So$e chains o+ stores o-erate on a +ranchise #asis, !here each store is o!ne
#y an ine-enent #usiness o-erator, !ho -ays a licence +ee +or the use o+ the
store na$e an +or costs such as avertising"
Ather chains $ay #e o-erate as traitional #usiness o-erations, !ith sta++
#eing e$-loye #y the co$-any an the +acilities #eing carrie on the
#alance sheet as assets"
A-erating a chain o+ si$ilar stores $ay allo! the #usiness to s-rea +i3e
costs, such as central a$inistration an avertising, across a large nu$#er o+
transactions"
Also, this $ay allo! larger a$ounts to #e s-ent on avertising than $ay #e
-ossi#le in the case o+ an iniviual o-eration"
=o!ever, this a--roach $ay only #e a--lica#le to certain ty-es o+
o-erations, an $any retail o-erations that service a s$all region $ay #e
o-erate as sole enter-rises"
5.34.2.11. 7tilities
Htilities inclue the su--ly o+ gas an electricity"
These inustries !ere o!ne an o-erate as state enter-rises in Australia
until recently"
7uring the 1660Cs, a $ove to a -rivately o!ne co$-etitive syste$ #egan"
100)
There are no! se-arate organisations involve in #uiling an o-erating
-o!er stations an gas istri#ution -i-elines, !holesaling o+ services +ro$
o-erators to retail organisations, an retail organisations that #uy services in
#ulk an istri#ute services to the general -u#lic"
This -rocess is only -artially co$-lete"
2or e3a$-le, the initial stage involve a s-eci+ic retail organisation +or each
area, an +ollo!ing an esta#lish$ent -hase to evelo- on<going o-erations,
the ne3t announce ste- has #een to allo! custo$ers to choose #et!een
i++erent su--liers"
Htilities are regulate inustries, !ith the -rices that can #e charge #eing set
#y a govern$ent regulatory authority"
In this conte3t, o-erating the #usiness $ay involve the control an
$anage$ent o+ costs, gaining e++iciencies through econo$ies o+ scale, an
su--lying aitional services to custo$ers on a +ee<+or<service #asis that are
se-arate +ro$ the regulate assets"
In so$e circu$stances, regulate -rices $ay #e eter$ine #y $easuring the
-ro+ita#ility o+ the co$-any, an a--lying a $ulti-le to eter$ine allo!e
-rices"
=o!ever, the result o+ this arrange$ent $ay #e that the net -ro+it o+ the
#usiness $ay not #e a#le to #e increase through traitional activities such as
increase econo$ies o+ scale or increase e++iciencies"
Any change to the #usiness o-eration $ay result in the regulate -rices #eing
altere to result in an unchange return +ro$ the #usiness"
This is the curse o+ the /o$$unist syste$, in !hich e++ort an actions $ay
#e -ointless, as no results $ay actually occur +or the -arty e3-ening the cost
or e++ort"
Managing a utility #usiness $ay involve increasing volu$es through
-ro$otion activities, or evelo-ing aitional services that o not +all !ithin
the category o+ the regulate activities"
1008
5.34.2.12. -anufaturing
Manu+acturing is a signi+icant -art o+ $ost evelo-e econo$ies, incluing
Australia"
This covers a !ie range o+ #usinesses an o-erations, +ro$ s$all enter-rises
conucting $anu+acturing o-erations, to large scale -rouction, such as
-rouction o+ cars an trucks"
Manu+acturing is a long<ter$ eclining inustry, as i$-rove$ents in
technology allo! the -roucts that $eet a $arket e$an to #e -rouce
!ith +e!er an +e!er resources"
Manu+acturing as a $a9or section o+ the econo$y is graually #eing re-lace
#y service #usinesses, !hich are a gro!th area o+ the econo$y"
S$all $anu+acturing o-erations $ay involve la#our intensive activities"
=o!ever, $anu+acturing is generally a ca-ital<intensive o-eration, re&uiring
ca-ital invest$ent in e&ui-$ent an -rouction +acilities"
'olu$es $ay #e a $a9or issue in $anu+acturing, as the +i3e costs o+ the
o-eration $ay #e a su#stantial -art o+ the total costs, an the cost -er unit
$ay +all as volu$es rise"
This $ay -articularly #e the case in the -rouction o+ co$$oity ite$s such
as televisions, !here a large nu$#er o+ $anu+actures $ay #e a#le to -rouce
si$ilar ite$s"
In these situations, -rices $ay #eco$e a $a9or +actor in a -urchase ecision"
This $ay lea to an inustry consoliating into a +e! $a9or $anu+acturers,
as the econo$ies o+ scale in large<scale -rouction $ay allo! ite$s to #e
-rouce at lo!er costs than in the case o+ s$all scale -roucers"
5.34.2.13. 'ir travel
Air travel $ay #e a ca-ital intensive #usiness, although in $any cases aircra+t
$ay #e lease rather than o!ne"
Air travel is also a service #usiness, an issues such as avertising, cor-orate
accounts an -ackage -roucts $ay #e relevant in the airline inustry"
1001
Load management
,oa $anage$ent $ay #e a $a9or issue in $anaging an airline"
The cost o+ +lying an aircra+t +ro$ one -oint to another $ay essentially #e a
+i3e cost, regarless o+ the nu$#er o+ -assengers travelling on the +light"
,oa $anage$ent $ay involve altering +light scheules, the nu$#er an si@e
o+ aircra+t, the -rice -er ticket, an iscount arrange$ents, to $a3i$ise
returns #ase on the nu$#er o+ +lights, an the average -ercentage o+ seats
that are +ille on each +light"
A regular scheule service that +lies #et!een t!o estinations, an carries a
single -assenger, $ay result in a large loss +or an airline"
=o!ever, +lights $ust #e $ae at the scheules ti$es, even i+ only a single
-assenger travels on a -articular +light"
In this situation, the +light $ust -rocee as scheule, even i+ this $ay result
in a signi+icant loss +or the airline"
,ndustr* structure
Air travel is a signi+icant inustry !orl !ie"
Air travel in $any countries $ay #e o$inate #y a single airline or a +e!
$a9or airlines, ue to the large ca-ital costs involve, an the lo!er -rices
that $ay #e charge #y large o-erations ue to econo$ies o+ scale"
=o!ever, the airline inustry in the Hnite States is highly co$-etitive, !ith
a large nu$#er o+ s$all airlines o-erating"
Air travel !orl<!ie $ay o-erate !ith sli$ $argins, ue to the co$-etition
o+ international +light routes #et!een i++erent airlines"
(>> check etails)
Dith only a +e! $anu+acturers o+ large aircra+t, an the selection o+ an
airline ticket #eing largely #ase on -rice, -rices $ay +all to the lo!est
sustaina#le levels ue to co$-etition on $a9or routes"
1006
In the case o+ o$estic air travel, $argins $ay vary consiera#ly +ro$
country to country, ue to the level o+ co$-etition an the activities o+
iniviual #usinesses !ithin each region"
Barriers to entr*
Barriers to entry $ay #e high !ithin the airline inustry, as the $ini$u$ si@e
o+ a co$$ercial airline o-eration $ay #e &uite large"
Beginning as a s$all airline an graually e3-aning $ay not #e -ractical on
$a9or routes, although this $ay occur in the case o+ regional airlines
servicing -articular areas"
Access to airline ter$inals $ay #e an issue !ith the esta#lish$ent o+ a ne!
airline" (>> check etails)
Regulations $ay vary +ro$ country to country in relation to leasing an
access to airline ter$inals"
Costs
Ma9or costs involve in o-erating an airline $ay inclue the e-reciation or
lease costs o+ aircra+t, $aintenance, sta++ costs, an aviation +uel"
The -rice o+ aviation +uel $ay #e highly volatile, #eing #ase on the oil -rice
!hich traes in o-en $arkets"
Also, it $ay not #e -ractical to -ass the changes in +uel -rices irectly on to
the ticket -rice, as ticket -rices $ay #e u-ate on an occasional #asis, !hile
the -rice o+ +uel $ay change aily"
Airlines $ay $anage this risk #y $aintaine a hege #ook o+ instru$ents
such as +utures contracts, to reuce the e3-osure o+ the airline to changes in
the -rice o+ aviation +uel"
5.34.2.14. #ervies
Service #usinesses co$-rise a large -art o+ the econo$y" (>> +igures)
Services inustries are a gro!th section o+ the econo$y, !ith ne! services
an ty-es o+ o-eration a--earing regularly"
10*0
This gro!th has #eco$e -ossi#le ue to technology i$-rove$ents that have
resulte in a reuction in the nu$#ers o+ -eo-le #eing e$-loye in
-reviously la#our<intensive inustries such as $anu+acturing, $ining,
-ri$ary -rouction an a$inistration services"
Service #usiness $ay inclue +inancial services such as #anking, insurance
an invest$ent $anage$ent, #usiness services such as -ro-erty
$anage$ent, -ro+essional services such as la!, an services such as esign
o-erations"
Service elivery $ay #e a la#our<intensive activity"
Service #usinesses $ay have lo! ca-ital re&uire$ents, an $ay o-erate on a
cash +lo! #asis"
Service #usinesses $ay also have a large -ro-ortion o+ varia#le costs rather
than +i3e costs, !ith volu$es #eing less i$-ortant in services than in other
inustries such as $anu+acturing"
So$e large service #usinesses are in o-eration, -articularly in insurance an
#anking"
=o!ever, $any service #usinesses $ay o-erate as s$all or $eiu$ si@e
enter-rises, incluing sole traers, -artnershi-s, s$all enter-rises, an
$eiu$ si@e liste -u#lic co$-anies"
This $ay occur ue to a lack o+ -otential econo$ies o+ scale in $any service
o-erations, an i++iculties in coorination !ithin large organisations"
Issues involve in service #usinesses $ay inclue evelo-ing a client #ase,
creating -roucts such as -ackage services that are attractive to -otential
clients, an reucing +i3e costs through $ethos such as -artnershi-s
sharing o++ice s-ace an a$inistration services"
5.34.2.14.1. 'sset management
Asset $anage$ent is a service #usiness"
2ees $ay #e charge +or the service o+ $anaging a -ort+olio o+ assets,
usually as a -ercentage o+ the -ort+olio si@e"
10*1
This $ay inclue -ort+olios o+ shares, -ro-erty, interest<#earings securities
such as govern$ent #ons, international shares, an in+rastructure assets such
as toll roas"
5roucts $ay inclue +uns that invest in a single ty-e o+ asset, such as
Australian shares, o+ +uns that $ay invest across several $a9or ty-es o+
asset"
,nsolvenc* risk
Assets !ithin invest$ent trusts an +uns $ay #e hel in the na$e o+ a
trustee, an the $anager o+ the +un $ay not have irect o!nershi- o+ the
assets"
The e++ect o+ this arrange$ent $ay #e that the assets o+ the +un are not
e3-ose to the risk o+ insolvency o+ the $anager"
I+ an asset $anage$ent co$-any ceases to o-erate, then an alternative
co$-any can #e a--ointe"
This $ay i++er +ro$ the case o+ insurance co$-anies an #anks, !here the
assets $ay #e hel !ithin the #alance sheet o+ the organisation"
A +ailure o+ the insurance co$-any or #ank in these situations $ay lea to a
loss o+ clientCs +uns"
Li)uidit*
=o!ever, li&uiity $ay #e an issue in the case o+ assets hel in trusts, rather
than assets hel on the #alance sheet o+ the organisation $anaging the +uns"
2or e3a$-le, !here a large nu$#er o+ investors $ay atte$-t to !ithra!
+uns +ro$ an invest$ent such as a -ro-erty trust !ithin a short -erio o+
ti$e, there $ay #e insu++icient cash hel !ithin the trust to $eet the
!ithra!als"
In this situation, long elays $ay occur until assets !ithin the +un $ay #e
sol to raise cash to $eet the ree$-tion re&uests"

,i&uiity $ay #e an avantage o+ the #alance<sheet a--roach to invest$ent
$anage$ent, use #y #anks an insurance co$-anies"
10*2
In the #alance<sheet a--roach, as the co$-any can -ay !ithra!als +ro$
e3isting cash reserves, an then sell assets at a later ate"
5.34.2.14.2. E(uation
%ucation is a service inustry"
A large -ro-ortion o+ eucation services in Australia are o-erate #y non<
co$$ercial organisations, an $ay #e +une through a co$#ination o+ +ees
charge +or courses an +uning +ro$ govern$ent revenues"
=o!ever, euction elivery is also conucte #y #usiness enter-rises"
This $ay -articularly a--ly in the case o+ technical +iels an -ro+essional
evelo-$ent eucation"
%ucation #usinesses $ay o-erate on a -urely cash +lo! #asis, using rente
or hire +acilities, !hile larger organisations $ay have su#stantial +i3e
assets in lan an #uilings"
5.34.2.14.3. 2ospitalit$
The hos-itality inustry inclues restaurants, hotels, acco$$oation, events
venues, an +acilities o+ all kins that -rovie +oo or acco$$oation to the
general -u#lic"
This $ay inclue a !ie range o+ +acilities an o-erations, ranging +ro$ a
single roo$ o+ acco$$oation, through to e3tensive resort co$-le3es"
=os-itality $ay #e a la#our<intensive service #usiness, !hich $ay o+ten
o-erate on a cash +lo! #asis"
Su--lies $ay #e a signi+icant issue in the case o+ restaurants an hotels, in
contrast to $any other service #usinesses, !hich $ay involve a range o+
activities such as a$inistration services, in !hich +e! su--lies or large
ite$s o+ e&ui-$ent $ay #e use"
10*3
Large 3otels
In the case o+ large city hotels, a nu$#er o+ international hotel chains $ay
o-erate hotels in $any large cities"
The :occu-ancy rate; o+ a hotel $ay #e an i$-ortant issue in $anaging a
hotel o-eration"
In a si$ilar !ay to airline seats, the nu$#er o+ availa#le roo$s is a +i3e
nu$#er, !hile $any costs $ay also #e at +i3e levels"
The occu-ancy rate re+ers to the -ercentage o+ roo$s that are occu-ie at any
-articular ti$e"
The average rate -er roo$ $ay also #e i$-ortant, !ith rates varying
accoring to the stanar rate, the nu$#er o+ #ulk iscount roo$s sol to
touris$ o-erators, iscounts an s-ecial o++ers, an so on"
Managing -rices, iscounts an -ro$otion activities $ay #e use to ensure
that the occu-ancy rate an the average roo$ rate re$ain at sustaina#le
levels"
1ther operations
Many hos-itality +acilities $ay #e o-erate as iniviual enter-rises"
Start<u- activities $ay #e co$$on in this inustry, an su--lies an
e&ui-$ent $ay #e reaily availa#le"
=o!ever, the +ailure rate o+ these o-erations $ay also #e high, an issues
such as the location o+ the o-eration $ay #e i$-ortant in ensuring that
custo$er levels reach sustaina#le levels"
The turn<over rate o+ hos-itality #usinesses $ay also #e high, an a large
nu$#er o+ hos-itality o-erations are avertise +or sale through #usiness
#rokers an various -u#lications"
In so$e cases, a #uiling $ay #e occu-ie #y several i++erent #usiness
o-erators !ithin the s-ace o+ a +e! years"
10*0
Seasonalit*
=os-itality $ay #e highly seasonal, !ith custo$er levels changing !ith the
ti$e o+ the year, an -ossi#ly !ith general econo$ic conitions"
Propert* investment vs! operations
In $any cases, #uilings $ay #e lease #y the #usiness o-erators"
This $ay a--ly in the case o+ restaurants, an also in the case o+ large hotels"
In cases !here the #uilings are o!ne, the #usiness $ay e++ectively #e s-lit
into t!o se-arate activities"
Ane activity $ay involve -ro-erty invest$ent, !ith ca-ital #eing raise to
-urchase the -ro-erty, an the inco$e +ro$ the #usiness o-eration
re-resenting a rental return on the #uilings"
The other activity $ay re-resent the +unction itsel+, such as +oo service or
acco$$oation activities"
This activity $ay #e revie!e on a cash +lo! #asis, !ith inco$e +ro$
custo$ers, an e3-enses incluing an e++ective rent co$-onent in relation to
occu-ying the #uiling"
5.34.2.14.4. Travel & Tourism
Travel $ay inclue air travel, coaches, rail an sea trans-ort"
These activities $ay #e ca-ital intensive, !ith vehicles having a high ca-ital
cost"
2uel $ay also #e a signi+icant e3-ense in so$e o-erations"
Many travel +acilities are o-erate #y organisations that $ay $aintain a large
nu$#er o+ se-arate trans-ort vehicles"
This $ay allo! the #usiness to o-erate a regular scheule o+ services"
A large #usiness $ay also have less i++iculty in raising ca-ital than a s$all
enter-rise in so$e circu$stances"
10**
Touris$ $ay inclue a !ie range o+ +acilities that $ay #e visite #y a large
nu$#er o+ o$estic or overseas custo$ers"
Touris$ +acilities $ay also involve a signi+icant ca-ital cost, an $ay re&uire
signi+icant levels o+ re<invest$ent o+ cash +lo! in orer to $aintain e3isting
+acilities an evelo- ne! +acilities"
Travel agencies are service #usinesses that o-erate !ithin the travel an
touris$ inustries"
Touris$ is e++ectively an e3-ort inustry, even though -roucts are not
e3-orte to overseas locations"
This occurs ue to the +act that the +ees -ai +or entry to +acilities #y overseas
visitors re-resent inco$e that is receive +ro$ overseas custo$ers"
In a si$ilar !ay, -er+or$ing contract services +or overseas custo$ers is also
e++ectively an e3-ort #usiness"
5.34.2.14.5. Entertainment
%ntertain$ent $ay inclue stage -rouctions, cine$as, an live
-er+or$ances"
2il$ an $usic -rouction $ay #e consiere a se-arate inustry to live
entertain$ent"
In the case o+ +il$ an $usic -rouction, o-erations $ay occur on a -ro9ect
#asis, !ith the large ca-ital cost o+ the -rouction #eing o++set #y inco$e
+ro$ licensing the co$-lete -roucts"
/ine$as are a istri#ution #usiness, receiving inco$e +ro$ custo$ers, an
-aying license +ees to +il$ stuios +or the right to -resent +il$s"
Television is also a istri#ution #usiness, although in so$e cases, television
o-erators $ay also -er+or$ -rouction activities, -roucing a range o+
television -rogra$s"
/ontent su--ly $ay #e an i$-ortant issue in the case o+ cine$as, television
an ne!s-a-ers"
10*)
In these situations, a continuous strea$ o+ ne! content $ay nee to #e
source +ro$ +il$ stuios, -rouction #usinesses an ne!s services in orer
to continue -resenting u-ate $aterial"
Inco$e +ro$ custo$ers $ay #e highly e-enant on the &uality an volu$e
o+ content that the istri#utor is a#le to source +or -resentation"
5rouction o+ stage sho!s an television -rogra$s $ay #e a ca-ital intensive
activity, involving e3-enses +or an e3tene -erio o+ ti$e, +ollo!e #y a
strea$ o+ inco$e +ro$ -resentations or licence +ees"
10*8
&. Summary of ma:or concepts & issues
A--earance vs"
%3istence
The a--earance o+ an o#9ect or situation $ay #e a
se-arate issue +ro$ the situation actually e3isting"
2or e3a$-le, a -ositive correlation $ay #e
calculate #et!een avertising e3-enses an sales
+igures"
This +igure $ay occur ue to the e3istence o+ a
link #et!een the t!o ite$s, or the +igure $ay #e
ue to rano$ chance, an no irect link $ay
actually e3ist"
Assets An asset is any ite$ o+ value that the #usiness
o!ns"
This $ay inclue so$e o+ the +ollo!ing ite$s"
,an an #uilings
%&ui-$ent
Manu+acturing +acilities
/ash
2inancial assets such as shares an #ons
Intangi#le assets such as -atents an
#ran na$es
A#stract -ro-erty such as $usic an
co$-uter so+t!are
Borro!ing .
,ening
Ite$s $ay #e lent an #orro!e in #usiness
activity"
In general, a regular +ee $ay #e -ai +ro$ the
#orro!er to the lener, +or each ti$e -erio that
the ite$ re$ains in the #orro!erCs -ossession"
This conce-t $ay #e a--lie to so$e o+ the
+ollo!ing situations
Asset 2ee
10*1
Builings Rent
Money Interest
%&ui-$ent =ire -ay$ents
/a-ital /a-ital re+ers to value"
This $ay also #e inter-rete as a large #lock o+
$oney"
/a-ital $ay re-resent a su$ o+ cash, a -hysical
asset, $oney o!e to the #usiness, or other ite$s
o+ value"
In contrast to the regular strea$ o+ inco$e an
e3-ense -ay$ents, ca-ital transactions $ay
involve #uying an selling assets, an large
trans+ers o+ cash or value that $ay occur on an
occasional #asis"
/ash +lo! transactions $ay +ocus on continuous
strea$s an totals<-er<-erio, !hile ca-ital
transactions $ay +ocus on iniviual trans+ers,
ine-enent o+ ti$e -erios"
/ash 's" 'alue /ash holings an trans+ers are a se-arate issue
+ro$ value holings an trans+ers"
A cash trans+er $ay occur !ithout a value trans+er"
Also, a value trans+er $ay occur !ithout a cash
trans+er"
2or e3a$-le, i+ cash is use to -urchase an ite$ o+
e&ui-$ent, the cash #alance o+ the #usiness $ay
reuce, ho!ever no change in total value $ay
occur"
In this case, value is si$-ly trans+erre into a
i++erent +or$, an the value hel #y the #usiness
oes not change"
/onversely, i+ the value o+ an asset rises or +alls,
the value o+ the #usiness holings $ay change,
10*6
even though no cash trans+er has occurre, an no
change has occurre in the cash #alance"
The holings o+ the #usiness are re-resente #y
value, not cash, !ith the cash #eing only one
co$-onent o+ the total value hel"
/ash, currency .
values
In the +inancial conte3t, :cash; $ay generally re+er
to the #alance o+ #ank accounts"
:/urrency; $ay re+er to coins an #ank notes, or
also to #alances hel in #ank accounts
The value o+ a li&ui asset such as a #on oes not
re-resent cash, #ut instea re-resents the value that
the asset $ay have i+ it !as sol in e3change +or
cash"
/urrency is an asset, an this $ay #e illustrate in
the case o+ +oreign currencies"
A #usiness $ay hol su$s o+ Fa-anese Wen, S!iss
2rancs, 4etherlans (uilers, an Australian
7ollars"
Money hel in Australian #ank accounts generally
re-resents a holing o+ Australian ollars"
/o$$ercial activity /o$$ercial activity $ay involve the +ollo!ing
activities
Trae Buying an selling assets,
$aterials an -roucts
5rouction Manu+acturing ite$s +ro$ ra!
$aterials, or creating a#stract
ite$s
Services 5er+or$ing services in e3change
+or -ay$ent"
/ontinuous .
-ro9ect #ase
activity
So$e #usiness activities are continuous, an $ay
involve a steay strea$ o+ inco$e an e3-enses"
10)0
Manu+acturing -rouction an service elivery
$ay #e e3a$-les o+ this ty-e o+ activity"
Ather #usiness activity $ay #e -ro9ect<#ase, an
$ay involve several stages an $ay o-erate +or a
+inite -erio o+ ti$e"
This $ay involve cash out+lo!s in the early stages
o+ a -ro9ect, +ollo!e #y cash in+lo!s +ro$
-rouct sales or license +ees"
5ro9ect<#ase activities $ay inclue +il$
-rouction, co$-uter so+t!are evelo-$ent,
construction -ro9ects, ne! -rouct evelo-$ents,
an avertising ca$-aigns"
7e#t 7e#t involves a situation in !hich $oney is o!e
to the #usiness, or the #usiness o!es $oney to
another -arty"
7e#t $ay arise ue to the re-ay$ent o+ $oney
that !as -reviously #orro!e, or ue to so$e
other reason, such as a -ay$ent #eing re&uire +or
a -rouct that has #een elivere"
7iversi+ication I+ a single large risk or e3-osure is s-lit into
several s$aller risks, the total volatility or risk o+
the activity $ay #e reuce"
2or e3a$-le, a #usiness that ha a large nu$#er o+
custo$ers or -er+or$e several activities $ay
have a less volatile cash +lo! an #e e3-ose to
less risk o+ a large +all in cash +lo! than a si$ilar<
si@e #usiness that only service a s$all nu$#er
o+ custo$ers or -er+or$e a single activity"
All else #eing e&ual, volatility or risk $ay
ecrease in -ro-ortion to the s&uare root o+ the
nu$#er o+ ine-enent risks !ithin the total"
2or e3a$-le
=umber
of
Total
,is6
,is6s
10)1
1 1""<
2 71<
3 58<
4 5"<
5 45<
1" 32<
1"" 1"<
1""" 3<
%&uity %&uity is another na$e +or the net assets o+ the
#usiness"
The e&uity value is e&ual to the total assets less the
e#ts o+ the #usiness"
This $ay #e re-resente in the +ollo!ing +or$ula"
e&uity P assets < e#ts
%&uity $ay #e vie!e in t!o !ays"
The shareholer<centre -ers-ective vie!s e&uity
as the o!nershi- o+ the #usiness assets"
The #usiness<centre -ers-ective vie!s e&uity as a
source o+ ca-ital, as an alternative to e#t, to #e
use in the o-eration o+ the #usiness"
%&uivalent
structures
In general, i++erent +inancial structures $ay #e
e&uivalent in the a#sence o+ i++erent interest rates
an rates o+ return"
2or e3a$-le, -urchasing a #uiling !ith cash has
the sa$e +inancial result as using a loan to
-urchase a -ro-erty, assu$ing that the e&uity
+uns coul #e investe in an alternative
invest$ent, returning the sa$e rate o+ return as the
e#t interest rate"
,easing a #uiling has the sa$e e++ect as
-urchasing the #uiling, i+ an e&uivalent a$ount o+
10)2
-ay$ents are investe in an alternative invest$ent
!ith the sa$e gearing level an rates o+ return as
the #uiling invest$ent"
In the case o+ loan structures, value is not irectly
gaine or lost si$-ly through changing to
alternative structures, such as an interest<only or
a$ortising loan"
2ee#ack 2ee#ack $ay involve checking or $easuring the
results o+ a -rocess"
This $ay #e an essential ste- in i$-roving a
-rocess"
Technically, the ter$ :+ee#ack; re+ers to a
-rocess in !hich the out-ut o+ the -rocess also
a++ects the in-ut, or $ay alter the -rocess itsel+"
2or e3a$-le, this $ay inclue issues such as
$easuring the -ercentage o+ +ault rates in a
-rouction -rocess, contacting custo$ers to check
that -roucts are elivere as orere an -er+or$
as e3-ecte, testing o+ -rouct -rototy-es, an
co$-aring the actual results o+ a -ro9ect
evelo-$ent against the original -ro9ect scheule"
Increasing -ro+it 5ro+it $ay #e increase in t!o +una$ental !ays"
Increasing inco$e
Reucing e3-enses
In -ractice, +uns $ay nee to #e investe in ne!
-roucts an u-ate +acilities, e&ui-$ent an
-rocesses, in orer to create a sta#le or increasing
inco$e"
,everage ,everage involves a situation in !hich a s$all
change in one value $ay -rouce a large change in
another value"
10)3
2inancial leverage occurs !hen a large asset an a
large e#t +igure are se-arate #y a s$all net asset
+igure"
In this situation, a s$all rise or +all in the asset
value $ay result in a large rise or +all in the net
asset value"
A-erational leverage occurs !hen the inco$e an
e3-ense +igures are large, an are se-arate #y a
s$all net -ro+it +igure"
In this situation, a s$all change in inco$e or
e3-enses $ay lea to a large change in net -ro+it"
5rouction leverage occurs !hen a high -ro-ortion
o+ the costs are +i3e costs"
In this situation, a s$all change in -rouction an
sales volu$es $ay result in a large change in net
-ro+it"
5ro#a#ility o+ cash
+lo!s
Hncertain +uture cash +lo!s $ay have a range o+
-ossi#le values"
This $ay inclue a cash +lo! than $ay or $ay not
occur, !ith either a +i3e value or a value o+ @ero"
Dhere a cash +lo! $ay have a range o+ -ossi#le
values, the e++ective value o+ the cash +lo! $ay #e
calculate +ro$ the -ossi#le values, an the
-ro#a#ility o+ each value occurring"
This $ay #e su$$arise in the +ollo!ing +or$ula
%++ective value P su$ o+ :-ro#a#ility 3 value; +or
each -ossi#le value o+ the cash +lo!
In the case o+ a cash +lo! !ith a single value that
$ay or $ay not occur, this +or$ula $ay reuce to
the +ollo!ing +or$ula"
10)0
'alue P -ro#a#ility 3 a$ount
In this +or$ula, the a$ount is the si@e o+ the cash
+lo!, an the -ro#a#ility is the -ro#a#ility that the
cash +lo! !ill occur"
I+ a cash +lo! $ay or $ay not occur, the e++ective
value o+ the -otential cash +lo! $ay #e lo!er than
the value o+ an e&uivalent cash +lo! that is
assu$e to #e certain to occur"
5rouction Manu+acturing involves creating -hysical ite$s
+ro$ ra! $aterials"
A#stract ite$s, such as #uiling esigns, $ay also
#e create uring #usiness activity"
5ro+it 5ro+it is the change in the #usiness assets, as a
result o+ #usiness activity"
This $ay #e re-resente in the +ollo!ing #asic
+or$
5ro+it P inco$e I e3-enses M rise or +all in asset
values
In the case o+ invest$ents such as -ro-erty
holings an shares, the asset values $ay rise"
=o!ever, in the case o+ general #usiness
o-erations involving e&ui-$ent, the asset values
$ay ecline, an this $ay #e recore as the
e-reciation value"
Services Services involve co$$ercial activity that oes not
involve creating ite$s, such as $anaging a -ro9ect,
or -er+or$ing $aintenance o+ e&ui-$ent"
Ti$e value o+
$oney
/ash +lo!s o+ the sa$e si@e that occur on i++erent
ates are not e&uivalent"
This $ay occur ue to the interest that coul #e
receive or charge on early inco$e or e3-ense
10)*
-ay$ents"
The -resent value o+ a +uture cash +lo! or asset
value $ay #e calculate using the +ollo!ing
+or$ula"
years of number
rate erest int
value future
value present

,
_

100
1

Trae Trae involves e3changing one ite$ +or another"
Trae $ay inclueE
:#uying;, e3change cash +or an ite$"
:selling;, e3changing an ite$ +or cash"
:#arter;, e3changing t!o -hysical ite$s"
:+oreign e3change;, e3changing a$ounts
in t!o currencies"
'alue is not gaine or lost irectly +ro$ a trae"
A trae si$-ly involves e3changing one ite$ +or
another ite$ o+ si$ilar value"
The value o+ a -rouct is create !hen the ite$ is
$ae, not !hen the ite$ is sol"
Selling a -rouct si$-ly involves e3changing an
ite$ +or an a$ount o+ cash o+ a si$ilar value"
10))
,ppen(i8 , 9 E8ample business plan
Description
Manu+acture o+ salt an -e--er shakers +or co$$ercial use
Participants
Bill S$ith, ,isa Fones, Sally McIntire, /hris ,ian, 5aul 7eveen"
Product opportunit* & "ackground
,isa has -reviously $anage a co++ee sho- an ha continual -ro#le$s !ith
usage an su--ly o+ salt an -e--er shakers"
The alternatives that are availa#le on the $arket at -resent are $anu+acture
in an area !ith $uch lo!er hu$iity than the area that the -ros-ective
#usiness o-erates in" As a conse&uence o+ this, salt shakers availa#le have
narro! holes, !hich +re&uently #eco$e #locke !ith a$- salt ue to the
hu$i conitions" This is a ti$e<consu$ing an +rustrating -rocess to
un#lock these"
Also, the co$$ercially availa#le salt an -e--er shakers are all
$anu+acture +ro$ glass, !hich leas to +re&uent #reakage"
(lass!are re-lace$ent is a regular cost o+ +oo service #usinesses such as
#ars an restaurants, an although it $ay not #e a $a9or e3-ense, it $ay #e
an aitional ite$ +or the #usiness to $anage"
Business concept
This #usiness -lan is #ase on -roucing stainless<steel co$$ercial salt an
-e--er shakers, as an alternative to the glass -roucts that are currently
availa#le"
10)8
The target $arket $ay initially involve +oo service #usinesses !ithin the
local region"
In the case o+ a success+ul evelo-$ent, e3-ansion $ay involve e3-aning
sales into a !ier area, or e3-aning into o$estic salt an -e--er shakers,
using a range o+ esigns +or househol use"
-est /arketing
Sa$-le stainless steel salt an -e--er shakers have #een $ae to e$onstrate
the iea"
,isa an /hris have a--roache a nu$#er o+ co++ee sho-s an restaurants to
gauge the rece-tion to the iea"
Although they $et !ith a $i3e rece-tion, so$e restaurant $anagers
res-one that they ha also e3-erience si$ilar -ro#le$s, an that they
!oul #e interesting in consiering the -roucts i+ they !ere availa#le on a
relia#le #asis at a si$ilar cost to the e3isting -roucts"
Skills & e%perience
,isa has -reviously $anage a co++ee sho- +or an e3tene -erio o+ ti$e,
an is +a$iliar !ith the orering -rocesses an o-erations o+ the +oo service
inustry"
/hris has e3-erience !ith s$all<scale e&ui-$ent o-eration, an is #roaly
&uali+ie to o-erate the $etal<-ressing e&ui-$ent that !oul #e neee to
-rouce the ite$s"
Sally has $anage a e-art$ent o+ a large $anu+acturing co$-any, an has
e3-erience !ith $anaging sta++, allocating #ugets an -roucing +inancial
an !ritten re-orts"
There is little e3-erience !ithin the grou- in ra! $aterials orering or
$arketing"
=o!ever, so$e early en&uiries !ith ra! $aterial su--liers have suggeste
that this area $ay not involve a great eal o+ i++iculty"
10)1
In ter$s o+ $arketing, a -lan has #een evelo-e to a--roach the $arketing
issues, as escri#e in the #usiness -lan"
+unding
/hris !ill #e investing G1* in ca-ital at the #eginning o+ the enter-rise, !hile
5aul !ill #e contri#uting G11 an ,isa !ill #e investing G10"
Bill an Sally !ill not #e investing initial ca-ital"
,nvolvement
5aul !ill #e a -assive investor, an !ill not #e involve in the o-erations o+
the enter-rise" A salary !ill not #e ra!n #y 5aul"
,isa, /hris an Sally !ill !ork on a +ull<ti$e #asis !ithin the o-erations"
Bill !ill !ork an e&uivalent o+ one ay a !eek $anaging the +inancial
arrange$ents, !ith the actual activity ha--ening in the evenings an
!eekens"
Salaries & investment
Salaries have #een allocate in the #uget +or ,isa, /hris, Sally an Bill"
Bill an ,isa !ill not #e ra!ing their salaries in cash, #ut !ill accu$ulate
the salaries as accounting entries in the #uget"
Dhen the enter-rise reaches a cash +lo! -ositive conition, the outstaning
a$ounts !ill #e -ai out +ro$ e3cess cash +lo!, an no aitional e3-enses
!ill #e $ae until the salary a$ounts are cleare"
7ue to the +act that the #usiness $ay +ail an that the outstaning salary
a$ounts $ay #e lost, Bill an ,isaCs salary a$ounts !ill #e 20L higher than
/hrisC, to co$-ensate +or the +act that /hris is ra!ing a salary in cash an
$ay +ace less risk that Bill an ,isa, an to co$-ensate o+ the inconvenience
o+ the elaye -ay$ent""
Bill an Sally are not investing +uns at the co$$ence$ent o+ the enter-rise"
10)6
=o!ever, #oth !ish to re<invest the salary a$ounts in shares in the
enter-rise"
The +inal share allocation +or each -erson !ill #e calculate +ro$ the total o+
the initial a$ount o+ $oney investe, -lus the salary a$ounts that are re<
investe to -urchase aitional shares"
Activit* schedule & time frames
Activities Target events
Month 1 5urchase . install
$etal -ressing
$achine"
Month 2 5rouce . istri#ute
sa$-les"
Arrange $aterial
su--lies an evelo-
o-erating -roceures"
%&ui-$ent +ully
installe an
o-erational"
Month 3 Re+ine test sa$-les an
alter esigns"
Month 0 Re+ine o-erating
-roceures"
Month * Arrange +ull su--ly
elivery"
Month ) /o$$ence +ull
-rouction"
Month 8 /o$$en ongoing
$arketing activities"
Mini$u$ ca-ital -oint"
Month 1 5ositive cash +lo!"
Month 6
Month 10
Month 11
Month 12
Month 13
Month 10
Month 1* Initial ca-ital level
recovere"
1080
Budget
The #uget +or the enter-rise is as +ollo!s
Inco$e %3-enses Re$aining 2uns
000
Month 1 0 100 300
Month 2 0 20 210
Month 3 0 10 280
Month 0 0 20 2*0
Month * 0 30 220
Month ) 30 00 210
Month 8 30 00 200
Month 1 *0 00 210
Month 6 *0 00 220
Month 10 80 00 2*0
Month 11 80 00 210
Month 12 80 00 310
Month 13 80 00 300
Month 10 80 00 380
Month 1* 80 00 000
Month 1) 80 00 030
Month 18 80 00 0)0
Month 11 80 00 060
A se-arate list o+ etaile e3-enses has #een ra!n u-, incluing a$ounts +or
cash salaries, a$ounts +or no$inal salaries to #e accu$ulate, avertising
e3-enses, rent, the -urchase o+ the $etal -ressing $achine, ra! $aterials,
-etrol . o++ice e3-enses, utilities incluing electricity . tele-hone costs, an
registration costs"
$oles & responsi"ilities
/hris !ill o-erate the $achinery an -rouce the +inishe ite$s"
Sally !ill -er+or$ the a$inistration, orer su--liers an eal !ith
custo$ers"
,isa an Bill !ill -er+or$ the sales an $arketing"
1081
Decision making & review
A co$-any !ill #e +or$e +or the enter-rise"
All +ive -artici-ants !ill #e irectors o+ the co$-any"
%ach -artici-ant has agree to the allocation o+ roles"
Ma9or ecisions !ill #e $ae through a $onthly $eeting o+ the +ull grou-"
Sally has #een given iscretion to s-en a$ounts u- to G* -er $onth +or
o++ice e3-enses !ithout a vote +ro$ the +ull grou-"
%ach -artici-ant has agree to a 12 $onth ti$e+ra$e +or the initial stage o+
the enter-rise"
At the en o+ the t!elve $onths, a vote !ill #e taken on !hether to continue
!ith the o-eration, or to !in u- the enter-rise"
In the event that a single iniviual !ithra!s +ro$ the o-eration #e+ore the
t!elve $onths has #een reache, a +ull $eeting !ill #e hel o+ the re$aining
-artici-ants, an a vote !ill #e taken on !hether to continue to the t!elve
$onth -oint or !hether to en the enter-rise at that ti$e"
-arget /arket
The initial target $arket involves restaurants an +oo service outlets !ithin
a regional area"
Accoring to a survey o+ tele-hone #ooks an restaurant irectories, there are
a--ro3i$ately 0*0 restaurants !ithin a region that is servicea#le #y car"
Success+ul sales to 10L o+ these restaurants !oul #e su++icient to reach a
#reak<even cash +lo!"
Beyon this, $arketing e3ercises coul #e conucte interstate !ithout any
great i++iculty"
/arketing approach
1082
,isa an #ill !ill conuct $arketing irectly !ith restaurants !ithin the
region"
This !ill #e one #y tele-hone contact, an arranging to e$onstrate the
ite$s !here -ossi#le to the -erson !ho selects the salt an -e--er shakers +or
orering"
A $ailing list o+ restaurants !ithin a !ier area has #een locate #y
contacting $arket research agencies, an a $ail out o+ lea+lets !ill #e
conucte to the restaurants !ithin the area"
/a2or risks
Although the ite$s !ill nee to #e re-lace on a regular #asis, they shoul
have a longer li+es-an that the e3isting glass ite$s"
There is a chance that there $ay #e an initial -erio o+ goo sales, an that
e3-ansion into a !ier area !ill #e neee to sustain the rate o+ sales, once
the e3isting $arket has #een saturate"
=o!ever, a+ter the t!elve $onth -erio, sales +ro$ the original area shoul
#egin to rea--ear as re-lace$ents are re&uire"
The $anu+acturing -rocess has not #een conucte #e+ore, an although
so$e sa$-les have #een $ae, there $ay #e teething -ro#le$s !ith the
actual -rouction"
Interest in the -rouct see$s goo, although there is no !ay to eter$ine the
actual result until -rouction co$$ences"
Backup facilities
I+ the #uget is $et an the esti$ate sales co$e through, then hal+ the initial
ca-ital !ill #e use #e+ore the cash +lo! #eco$es -ositive"
This leaves the other hal+ o+ the initial ca-ital to hanle une3-ecte e3-enses
an -ro#le$s that $ay occur #e+ore the cash +lo! #eco$es -ositive"
Bill !oul -re+er not to -er+or$ the $arketing -rocess, ho!ever he has
agree to allocate an aitional ay each !eek i+ ,isa an Bill +in that the
1083
ti$e elay involve in e$onstrations is -reventing enough initial sales +ro$
#eing $ae"
(%pansion possi"ilities
In the event that the enter-rise reaches cash +lo! -ositive an sales are
steay, several +uture irections coul #e taken"
These inclue e3-ansion interstate, an e3-ansion into o$estic salt an
-e--er shakers"
Investigation has eter$ine that o$estic ite$s are generally $anu+acture
#y $anu+acturers o+ general househol su--lies, as -art o+ a !ie range o+
kitchen i$-le$ents"
This $ay #e a s$all -art o+ these co$-anyCs -rouct lines, an no -articular
attention see$s to #e -ai to the esign or o-eration o+ the o$estic salt an
-e--er shakers"
This coul -rovie the o--ortunity +or a range o+ s-ecialist ite$s, !ith higher
&uality $echanis$s an a range o+ i++erent esigns"
5ossi#le long<ter$ o-tions have #een iscusse in general as -art o+ the
#usiness -lan -re-aration"

In the #usiness reaches a sta#le cash +lo!<-ositive situation, a +ull revie! o+
+uture -ossi#ilities !ill #e $ae at that -oint"
This $ay involve a t!o<ay +ull ti$e revie! -rocess, !ith each $e$#er o+
the grou- #rie+ly su$$arising their thoughts on the +uture irection, +ollo!e
#y etaile iscussion o+ the -ossi#ilities"
,isa has agree to -re-are a list at the ti$e o+ the revie! o+ the -ossi#le
volu$e o+ sales that coul #e achieve +or each alternative, !hile 5aul !ill
arrange &uotes +or su--lies an cost a$ounts"
(%it Arrangements
A+ter a +our year -erio, i+ the enter-rise is still o-erating an one o+ the
-artici-ants !ishes to e3it, an ine-enent valuation o+ the shares !ill #e
arrange"
1080
Any cash !ithin the co$-any, a-art +ro$ a #u++er +or !orking ca-ital, !ill
then #e use to re-urchase the -artici-antCs shares at the valuation -rice"
I+ there is insu++icient cash availa#le, then the inco$e +ro$ o-erations !ill #e
s-lit in hal+"
=al+ the inco$e !ill #e availa#le +or iviens an reinvest$ent, !hile the
other hal+ !ill #e use to re-urchase the shares until all the shares have #een
re-urchase"
I+ $ore than one -artici-ant !ishes to e3it, the availa#le cash !ill #e use to
re-urchase the shares o+ each -artici-ant on a -ro<rata #asis"
In the case that all the -artici-ants !ish to e3it, an the #usiness is still in
o-eration, the #usiness !ill #e o++ere +or sale"
I+ a #uyer is not locate !ithin a reasona#le -erio o+ ti$e, then the co$-any
!ill #e !oun u-"
108*
,ppen(i8 B 9 E8ample Service Contract
The +ollo!ing e3a$-le etails a -ossi#le service contract or internal service
level agree$ent"
An actual service contract or service level agree$ent $ay involve $ore
etaile te3t than this e3a$-le"
=o!ever, this e3a$-le $ay e$onstrate so$e o+ the key -oints an issues
that $ay #e raise"
5arties This service contract is #et!een co$-any AB/, the
:client;, an co$-any ?WX, the :service -rovier;,
+or the -rovision o+ a$inistration services in regar
to retail electricity connections"
Services Scheule ?? contains a list o+ the services to #e
-rovie"
These are
A$inistration o+ custo$er a--lications to connect
an isconnect electricity services"
Billing o+ custo$ers +or electricity usage"
Manage$ent o+ overue accounts"
5roviing custo$er su--ort services
through tele-hone contact"
Maintaining recors o+ custo$er etails an
accounts"
5roviing $ail<outs to custo$ers as s-eci+ie in this
agree$ent"
/usto$er
Mailouts
The service -rovier !ill -er+or$ $ail<outs o+ letters
to custo$ers, in the +or$at -rovie #y the client,
an to the s-eci+ie grou- o+ custo$ers"
2ees The +ollo!ing +ees !ill a--ly
A connection re&uest
G1"00 -er transaction
108)
A isconnection re&uest
G"10 -er transaction
Alteration to etails or service
G 1"30 -er transaction
/usto$er service -rovision
G 1230 $onthly
Mail<outs
G123 -lus G0"03 -er ite$
Re-orting A re-ort shoul #e su#$itte $onthly to the client,
containing the +ollo!ing etails"
The nu$#er o+ transactions -rocesse o+ each ty-e"
The current nu$#er o+ custo$ers !ith each account
ty-e"
The average res-onse ti$e to tele-hone en&uiries"
7etails o+ res-onse ti$es as liste #elo!"
The average -rocessing ti$e +or transaction re&uests"
The nu$#er . a$ount o+ overue accounts"
Statistics shoul #e calculate +ro$ co$-uterise
recors o+ res-onse ti$es an -rocessing volu$es"
Service ,evels Service levels shoul $eet the +ollo!ing criteria
The average ti$e taken to ans!er tele-hone
en&uiries shoul not to e3cee 3 $inutes +or the
co$-lete $onth"
66L o+ tele-hone en&uiries shoul #e ans!ere
!ithin 8 $inutes"
The average ti$e taken to ans!er tele-hone
en&uiries, uring -eak ti$es, shoul not to e3cee *
$inutes +or $ore then 10 hours uring the $onth,
!ith each calculation #ase on !hole hours
#eginning at 1E00 +or e3a$-le"
Average -rocessing ti$e +or transactions shoul not
e3cee 2 ays"
6*L o+ transactions shoul #e -rocesse !ithin *
ays"
1088
/usto$er Service %ach one<thousanth custo$er en&uiry to result in
the custo$er #eing to #e aske !hether they !oul
like to co$-lete a short custo$er service survey, in
return +or G10 iscount on their ne3t account"
The selection o+ the custo$er to #e #ase on
auto$atic selection, #y the co$-uterise tele-hone
-rocessing syste$"
Survey &uestions are attache in scheule ??"
Rating o+ overall service, an service +or a -articular
en&uiry, not to e3cee 20L ratings +or :average;, or
10L ratings +or :-oor; or :very -oor;
'olu$es The +ollo!ing volu$es $ay a--ly to this service
Transactions 1230 -er $onth
Tele-hone en&uiries 12230 -er $onth
In cases !here the nu$#er o+ transactions e3cees
this level, service !ill continue on a :#est
eneavours; #asis, ho!ever -enalties +or +ailing to
$eet the s-eci+ie res-onse ti$es !ill not a--ly"
Re&uire$ents +or custo$er service stanars !ill
continue to a--ly"
5ay$ent Ter$s 5ay$ents are ue 30 ays a+ter the issue o+ an
invoice to the client"
7e+aults an
5enalties
Averue accounts
5ay$ents ue that are not receive in +ull !ithin 8
ays a+ter the ue ate !ill attract an a$inistration
+ee o+ G10, an interest calculate +ro$ the ue ate
at the rate o+ 12L -er annu$" The +ee !ill #e ae
to the e3isting account, !hile interest !ill #e ae
to the +ollo!ing account
Service Stanars
1081
Dhere service stanars that are liste in this
agree$ent are not $et, the +ee +or that $onth !ill #e
-aya#le at the o-tion o+ the client"
The client $ust give notice o+ electing to e3ercise the
o-tion to ecline -ay$ent !ithin 8 ays a+ter
receiving the invoice, other!ise the account #eco$es
-aya#le"
This o-tion oes not accu$ulate, an a -ay$ent o+
an account cannot #e reverse in a +ollo!ing $onth"
Dithra!al o+ service
I+ any -ay$ent has not #een receive !ithin 60 ays
a+ter the ue ate, the service -rovier $ay !ithra!
service, either te$-orarily or -er$anently" A$ounts
receive +ro$ the client are to #e a--lie to the
account that has the longest -erio o+ ti$e since the
ue ate"
A!nershi- A+
in+or$ation
In+or$ation incluing custo$er etails, account
etails, an transaction histories re$ains the -ro-erty
o+ the client" The service -rovier $ust $aintain
ae&uate #ack<u- +acilities +or co$-uter ata
storage, an these +acilities $ay #e ins-ecte #y the
client on a se$i<annual #asis"
5ay$ent
Authority
All -ay$ents an recei-ts !ill #e -rocesse through
accounts in the clientCs na$e"
The service -rovier is grante authority, #y this
contract, to $ake -ay$ents to custo$ers regaring
re+uns o+ creit account #alances"
/reit risk .
overue Accounts
/reit risk re$ains !ith the client" Averue accounts
are to #e -rocesse !ith t!o re$iner letters"
Accounts overue #y $ore than 60 ays !ill #e
re+erre to a se-arate e#t collection agency"
Auiting 2inancial accounts !ill #e auite #y e3ternal
1086
auitors"
/usto$er service stanars !ill #e auite #y a
+or$al custo$er service auit, conucte #y an
e3ternal agency" This !ill inclue su#$itting
anony$ous transactions, an contacting custo$ers
irectly to assess custo$er service stanars"
Ter$ination o+
Agree$ent
%ither -arty to this agree$ent $ay ter$inate the
contract #y giving 60 ays notice in !riting to the
other -arty, o+ an intention to !ithra! +ro$ the
agree$ent"
1010
1011
,ppen(i8 C 9 Sample legal (ocuments
(>> $ortgage etc)
Contract
/ontract o+ Sale
It is here#y agree that Mary Fane S$ith !ill sell the -ro-erty at 23 Ma-le
/ourt to Susan Fones +or the su$ o+ one hunre ollars, !ith the transaction
to #e settle on the 0
th
o+ 4ove$#er 2001"
(signature an ate) (signature an ate)
Mary Fane S$ith Susan Fones
1012
*eceipt
This state$ent ackno!leges that +i+ty ollars has #een receive #y
/hristo-her McIntire +ro$ Bill Fones as +ull -ay$ent +or the -ro-erty at *3
Acacia Roa"
(signature an ate)
/hristo-her McIntire
1013
'oan
An agree$ent is here#y $ae +or Bill S$ith to loan 5aul 'ale ten ollars"
Interest !ill #e ue &uarterly at the rate o+ eight -ercent -er annu$, #ase on
the -rinci-al a$ount outstaning on each ay through the &uarter"
Interest -ay$ent ates !ill #e the 31
st
o+ March, the 30
th
o+ Fune, the 30
th
o+
Se-te$#er an the 31
st
o+ 7ece$#er"
The -rinci-al a$ount !ill #e re-ai at the en o+ a +ive year -erio, #eing the
ate 12
th
Fune 2003"
5rinci-al a$ounts $ay #e re-ai earlier #y 5aul at any ti$e"
5art o+ the loan -rinci-al, or the entire outstaning loan a$ount, $ay #e
calle +or re-ay$ent on ninety ays notice issue #y Bill to 5aul"
(signe an ate) (signe an ate)
Bill S$ith 5aul 'ale
1010
,ppointment of an agent
Authorisation to act as an agent
I, ,ouise Fones, here#y authorise Sally AC#rien to #i +or the -urchase o+ the
-ro-erty at *62 South Roa on $y #ehal+ as $y agent, !ith the $a3i$u$
#i loge not to e3cee thirty ollars"
(signature an ate)
,ouise Fones
101*
Trust (ee( (>> check etails)
7ee o+ trust
It is sole$nly eclare that the lan an #uilings at 03 Blake Street, together
!ith a su$ o+ ten ollars, !ill #e trans+erre +ro$ Marly Ivain o+ 82 Branch
Street, as settlor (>>check), to Ignatius S$ith o+ 32 =ill Street, as trustee, to
#e hel on trust on #ehal+ o+ Michael Fones o+ )2 Bunton ,ane, as
#ene+iciary, until he reaches eighteen years o+ age"
Inco$e Inco$e +ro$ the trust -ro-erty, incluing rents
an interest, is to #e hel as trust -ro-erty an
inclue !ith the +uns to #e trans+erre on e3-iry
o+ this arrange$ent"
Trust %3-enses %3-enses relate to $aintaining an $anaging the
trust -ro-erty, incluing -ro-erty $aintenance
costs, insurances, ta3es, -ro-erty $anage$ent
+ees an so +orth $ay #e ra!n +ro$ the trust
+uns"
Trustee e3-enses The trustee $ay ra! +uns +ro$ the trust +or
reasona#le e3-enses incurre in a$inistering the
trust, incluing legal costs an travel e3-enses"
Resignation o+ trustee The trustee $ay resign +ro$ this trust arrange$ent
#y issuing a eclaration o+ resignation, an
a--ointing an alternative -arty !ho consents to
holing the trust -ro-erty uner this trust
arrange$ent"
Revocation This trust arrange$ent $ay #e revoke #y a notice
issue #y the settlor, in !hich case the trust
-ro-erty !ill #e returne to the settlor
Signe, seale an elivere at 82 Branch Street on 12 Fuly, 2001
(signature an ate)
Marly Ivain
101)
,ppen(i8 D 9 *atios an( margins by in(ustry
(>> su$$ary o+ ranges +or ratios, $argins etc +or various inustries an ty-es
o+ #usiness)
1018
1011
,ppen(i8 E 9 6onthly repayments of an amortising loan
Re-ay$ents -er G1,000 o+ loan -rinci-al"
=umber of 4nterest ,ate
;ears 5."< !."< 7."< 8."< 9."< 1"."< 11."< 12."< 13."< 14."< 15."< 1!."< 17."< 18."<
1 85.!1 8!."7 8!.53 8!.99 87.45 87.92 88.38 88.85 89.32 89.79 9".2! 9".73 91.2" 91.!8
2 43.87 44.32 44.77 45.23 45.!8 4!.14 4!.!1 47."7 47.54 48."1 48.49 48.9! 49.44 49.92
3 29.97 3".42 3".88 31.34 31.8" 32.27 32.74 33.21 33.!9 34.18 34.!7 35.1! 35.!5 3!.15
4 23."3 23.49 23.95 24.41 24.89 25.3! 25.85 2!.33 2!.83 27.33 27.83 28.34 28.8! 29.37
5 18.87 19.33 19.8" 2".28 2".7! 21.25 21.74 22.24 22.75 23.27 23.79 24.32 24.85 25.39
! 1!.1" 1!.57 17."5 17.53 18."3 18.53 19."3 19.55 2"."7 2".!1 21.15 21.!9 22.25 22.81
7 14.13 14.!1 15."9 15.59 1!."9 1!.!" 17.12 17.!5 18.19 18.74 19.3" 19.8! 2".44 21."2
8 12.!! 13.14 13.!3 14.14 14.!5 15.17 15.71 1!.25 1!.81 17.37 17.95 18.53 19.12 19.72
9 11.52 12."1 12.51 13."2 13.54 14."8 14.!3 15.18 15.75 1!.33 1!.92 17.53 18.14 18.7!
1" 1".!1 11.1" 11.!1 12.13 12.!7 13.22 13.78 14.35 14.93 15.53 1!.13 1!.75 17.38 18."2
11 9.8! 1".37 1".88 11.42 11.9! 12.52 13."9 13.!8 14.28 14.89 15.51 1!.14 1!.79 17.44
12 9.25 9.7! 1".28 1".82 11.38 11.95 12.54 13.13 13.75 14.37 15."1 15.!! 1!.32 1!.99
13 8.73 9.25 9.78 1".33 1".9" 11.48 12."8 12.!9 13.31 13.95 14.!" 15.27 15.94 1!.!3
14 8.29 8.81 9.35 9.91 1".49 11."8 11.!9 12.31 12.95 13.!" 14.27 14.95 15.!4 1!.34
15 7.91 8.44 8.99 9.5! 1".14 1".75 11.37 12."" 12.!5 13.32 14."" 14.!9 15.39 1!.1"
1! 7.58 8.11 8.!7 9.25 9.85 1".4! 11."9 11.74 12.4" 13."8 13.77 14.47 15.19 15.91
17 7.29 7.83 8.4" 8.98 9.59 1".21 1".85 11.51 12.19 12.87 13.58 14.29 15."2 15.7!
18 7."3 7.58 8.1! 8.75 9.3! 1"."" 1".!5 11.32 12."" 12.7" 13.42 14.14 14.88 15.!3
19 !.8" 7.3! 7.94 8.55 9.17 9.81 1".47 11.15 11.85 12.5! 13.28 14."2 14.7! 15.52
2" !.!" 7.1! 7.75 8.3! 9."" 9.!5 1".32 11."1 11.72 12.44 13.17 13.91 14.!7 15.43
21 !.42 !.99 7.58 8.2" 8.85 9.51 1".19 1".89 11.!" 12.33 13."7 13.82 14.59 15.3!
22 !.25 !.83 7.43 8."! 8.71 9.38 1"."7 1".78 11.5" 12.24 12.99 13.75 14.52 15.3"
23 !.1" !.!9 7.3" 7.93 8.59 9.27 9.97 1".!9 11.42 12.1! 12.92 13.!9 14.4! 15.25
24 5.97 !.5! 7.18 7.82 8.49 9.17 9.88 1".!" 11.34 12.1" 12.8! 13.!3 14.42 15.21
25 5.85 !.44 7."7 7.72 8.39 9."9 9.8" 1".53 11.28 12."4 12.81 13.59 14.38 15.17
Re-ay$ents can #e calculate #y $ulti-lying the a$ount +ro$ the ta#le #y the nu$#er o+ thousans o+ ollars o+ the loan a$ount"
2or e3a$-le, a loan o+ G*,000 at 6L interest over * years !oul have re-ay$ents o+ 20"8) 3 * P G103"10 -er $onth"
1016
,ppen(i8 5 ; 6o(el ,ccounts
(>> +ull set o+ $oel accounts)
1060
,ppen(i8 $ ; Sample basic accounts & analysis
(>> sa$-le #asic accounts, $argins an ratios)
1061
,ppen(i8 < ; Option 3ricing
(>> o-tion -ricing #ook$ark )
(>> #lack . scholes $oel)
1062
,ppen(i8 2 9 Summary of formulas
(>> +or$ula su$$ary #ook$ark)
Conventions an( symbols
y The interest rate -er -erio, in eci$al +or$at
n The total nu$#er o+ -erios
a$ount The value o+ a single cash +lo!
-ay$ent Thr -ay$ent a$ount -er -erio
-resent value The value on the current ate, or an early ate
+uture value The value at a +uture ate
All interest rates an iscount rates are use in eci$al +or$at in this section,
not -ercentage +or$at"
2or e3a$-le, an interest rate o+ 1"*L !oul #e inclue in a calculation as
0"01*"
Sum
The +ollo!ing sy$#ol $eans :the su$ o+;" This sy$#ol is the u--ercase
(reek letter :sig$a;"

This involves aing the iniviual nu$#ers together"

2or e3a$-le, a situation $ay involve three interest rates, 10L, 3L an 8L"
1063
The +ollo!ing re-resentation coul #e use to re-resent the su$ o+ the three
values"
Total P

rate erest int

P 10 M 3 M 8
P 20
This coul also #e e3-resse in the +or$

i
i
x
Product
The +ollo!ing sy$#ol $eans :the -rouct o+;" This involves the nu$#ers
#eing $ulti-lie together"
The sy$#ol is the u--ercase (reek letter :5i;"

2or e3a$-le, three values $ay #e involve in a -articular situation, 1"2, 1"*
an 1"1"
The -rouct o+ the three values coul #e e3-resse in the +ollo!ing !ay"
Total P

values
P 1"2 3 1"* 3 1"1
P 1"61
This coul also #e e3-resse in the +ollo!ing !ay"
1060

i
i
x
106*
3ro(uction vs. 'icensing
5rouction (-ro+it -er -erio)
( ) period per t cos fixed units of number unit per t cos unit per price profit
,icensing (-ro+it since -ro9ect co$$ence$ent)
t cos t developmen total units of number unit per price sale profit
3er9Share 5igures
share per dividends total
payments dividend total
shares of number
shares of number
amount total
share per amount
shares of number share per amount amount total
shares of number price share value l operationa
6argins & ratios
revenue
EBITDA
in arg m profit gross
revenue
EBIT
in arg m EBIT
revenue
profit net
in arg m profit net
106)
on depreciati
enditure exp capital
ratio ansion exp capital
assets
debt
gearing
erest int
EBIT
er cov Interest
profit net
paymeny dividend
ratio payout
share per earnings
share per dividend
ratio payout
=iel(s & *eturns
Assets
EBIT
assets on return
e!uity
profit net
e!uity on return
( ) ( )

,
_

+ rate erest int debt "#A

g
g
"#A rate tax "#E
1
1

g P gearing ratio
e!uity
rate return e!uity e!uity profit net
e!uity on return excess

assets
rate return e!uity e!uity profit net
assets on return excess

1068
value l operationa
profit net
yield earnings
price share
share per earnings
yield earnings
ratio earnings price
yield earnings
1

value l operationa
profit net
yield earnings
yield earnings
ratio earnings price
1

price share
share per dividend
yield dividend
1
value present
value future
return
1 1

,
_

+

i
i
r return total
1 1
1

,
_

+
n
i
i
r average geometric

Debt rates & payments
3)* 100
days of number rate erest int
principal erest int
principal total
loan each for ' rate erest int principal ' of sum
rate average

1061
debt
ense exp erest int
rate average
(historical average)
6anufacturing
5rouction
100
plant the of capacity design
produced items of number
n urilisatio capacity
produced items of number
used material of volume
item per usage materials
100
used material of volume
products finished in material of volume
efficiency usage materials
100
production potential of hours tota
use for availabile hours
rate ty availabili
produced items of number total
produced items faulty of number
rate fault
5lant structure
100
+

ts cos labour on depreciati

on depreciati
level automation
items of number
item each of age the of sum
age e!uipment average
100

machines of number total
machines ng depreciati non of number
e!uipment ng depreciati non
100

ts cos ia0le 4ar total
e!uipment ng depreciati non 0" used ts cos ia0le 4ar
e!uipment ng depreciati non
1066
ts cos occupancy building
assets facilities & e!uipment
ensity int capital ocupancy
ts cos occupancy building
profit net
n utilisatio occupancy
time do(n average time run average
time run average
capacity machine capacity production
+

2i3e . varia#le costs
units num
ts cos fixed
unit per t cos iable var unit per t cos +
n utilisatio capacity volume design
t cos fixed
unit per t cos iable var unit per t cos

+
units num
ts cos fixed
unit per t cos fixed
n utilisatio capacity volume design
t cos fixed
unit per t cos fixed

Margins . returns
( )
( ) ts cos fixed t cos iable var unit price sale unit units num
t cos iable var unit price sale unit units num
leverage production

unit per t cos iable var unit per price sale

ts cos fixed
volume sales even brea$

( )
unit per price sale
unit per t cos iable var unit per price sale
in arg m production

( )
unit per price sale units num
ts cos fixed unit per t cos iable var unit per price sale units num
in arg m sales

assets
tax & erest int before earnings
assets on return
ratio t cos fixed n utilisatio capacity in arg m production capacity sales "#A
1100
Ter$s +or the RAA +or$ula
assets
volume design
price sales capacity sales
assets
ts cos fixed
ratio t cos fixed
capacity volume design
produced units of number
n utilisatio capacity
( ) ts cos fixed unit per t cos iable var unit per price sale sales num profit net
ts cos fixed value sales in arg m production profit net
( ) ts cos fixed capacit" design n utilisatio capacit" unit per t cos ia0le 4ar unit per price sale profit net
Economies of scale
b
volume a unit per t cos
( ) ( ) 1 2
1
2
volume ln volume ln
t cos
t cos
ln
b

,
_

b
volume t cos a

1 1
Single -rouction volu$e . cost ata
( ) 1 +

b
volume ts cos total a
Rule o+ thu$#
# P <0"80 (>> check)
80 0.
volume unit per t cos a
1101
(>> econo$ies o+ scale calcs, e3-onential curves using various #ases vs"
-olyno$ial curves)
3robability
occuring of y probabilit occuring not of y probabilit 1
y probabilit trials of number events of number average
%&ually likely events
items of number
y probabilit
1

=istorical events
value or events total
value or events actual
y probabilit
Hncertain cash +lo!s
y probabilit amount value

outcome possible each for ' y probabilit value ' of sum value

i
i i
value y probabilit value
Multi-le outco$es o+ a single event
' b ' outcome of y probabilit ' a ' outcome of y probabilit ' b ' or ' a ' outcome of y probabilit +
T!o se-arate events #oth occurring
' b ' of y probabilit ' a ' of y probabilit ' b ' and ' a ' both of y probabilit
1102
Ti$e<#ase events
( )
periods of number
y probabilit 8 period 8 gle sin y probabilit 1 1
7iscrete linear istri#utions
outcomes possible of number
y probabilit
1

/ontinuous linear istri#utions

value possible imum min value possible imum max
value range imum min value range imum max
y probabilit

7elta
price mar$et (orstcase at value value current loss imum max
price input the in change small a
price output the in change the
delta
Correlation & regression
(>> correlation . regression +or$ulas)
n correlatio n correlatio s!uared r
b firstvalue a ondvalue sec +
n correlatio
series data first of deviation dard tan s
series data ond sec of deviation dard tan s
a
1103
,ccuracy tests
(>> con+ience intervals, t<tests
Stan(ar( Deviation
(>> stanar eviation +or$ula)
periods of number period per deviation dard tan s deviation dard tan s
5ort+olio stanar eviation
r sd sd ( ( of ns combinatio all of sum deviation dard tan s
2 1 2 1

i *
* ) i * i * i p
r ( (
2
5ort+olio stanar eviation, ine-enent varia#les
asset each for deviation dard tan s ( of sum deviation dard tan s
2 2

i
i i p
(
2 2 2

5ort+olio stanar eviation, ine-enent varia#les, e&ually !eighte
ris$s of number
ris$ individual an of devaiation dard tan s
deviation dard tan s
%3tre$e $ove$ents
2i3e average
average value ne( change the of si6e
deviation dard tan s deviations d tan s of number average value lo(er
deviation dard tan s deviations d tan s of number average value upper +
1100
Rano$ !alk
value old
value old value ne(
change of si6e

deviation dard tan s deviations d tan s of number 7 value current value upper + 1
deviation dard tan s deviations d tan s of number 7 value current value lo(er 1
deviation dard tan s
change the of si6e
deviations dard tan s of number
3resent & future values
( )
n
y
amount
value present
+

1
( )
n
y amount value future + 1
5art o+ one -erio

,
_

y
period in days
days
amount
value present
1

,
_

+ y
period in days
days
amount value future 1
Multi-le -erios, not $atching !hole -erios
( )
period in days
days
y
amount
value present
+

1
( )
period in days
days
y amount value future + 1
110*
Annuities
( )
y
y
payment value present
n
+

1 1
( )
y
y
payment value future
n
1 1 +

(ro!th annuities
( )
( )
1
1
]
1

+
+

+
g
y
g
y g
payment
value present
n
n
1
1
1
1
( ) ( ) ( ) [ ]
n n
9 y 7 g g
y g
amount
value future + + +

1 1 1
(ro!th annuity !here yPg
n payment value present
( )
n
y n payment value future + 1
5er-etual annuity
y
payment
value present
(ro!th -er-etual annuity
g y
amount
value present

yYg
A$ortising loan
110)
( )
n
y
y
value loan payment

+

1 1
Sinking +un
( ) 1 1 +

n
y
y
value future payment
%$#ee interest rates in an a$ortising loan structure
( )
0
1 1

+

principal
y
y
payment
n
*ate & perio( conversions
100
rate percentage
rate decimal
100 rate decimal rate percentage
years of number year per periods periods of number
year per periods
rate annual al min no
period per rate
payment year per periods payment annual
period per rate year per periods rate annual
1 1

,
_

+
year per periods num
year per periods num
rate annual al min no
rate annual effective
( ) 1 1
1
+

,
_

year per perionds num

rate annual effective rate annual al min no
1108
( ) rate annual effective ln rate g compoundin ly continuous + 1
Different compoun(ing & payment fre4uencies
years of number year per periods g compoundin periods of number
year per periods g compoundin
rate erest int annual al min no
rate erest int
year per periods g compoundin
year per periods payment
payment actual payment effective
year per periods payment
year per periods g compoundin
payment effective payment actual
1aluation multiples
multiple amount value
amount
value sale
multiple
yield
multiple
100

multiple
yield
100

Orthogonal selection
co$#inations P the nu$#er o+ o-tions +or each -ara$eter,
$ulti-lie together
1101
Sensitivities
change input multiple y sensitivit change output
100

value old
value old value ne(
change
100
change percentage
amount original change actual
Regression sensitivity
b value input a value output +
input in change dollar a output in change dollar
value output
value input
a multiple y sensitivit
Ti$e sensitivities
enses exp income
enses exp
y sencitivit time

change percentage time y sensitivit time change percentage profit net

/"pe Value
Affected
2ormula Description
Operational
sensiti4it"
'operationa
l le4erage)
Gross cash
flo+
income
AAAAAAAAAA
income A expenses
/he multiple of change in cash
flo+ to change in either income
or expenses
Asset
sensiti4it"
'financial
le4erage)
E!uit" 'Net
assets)
assets
AAAAAAAAAAAAAA
assets A de0ts
/he multiple of the change in
e!uit" to the change in asset
4alues
Interest Net cash interest expense /he multiple of change in net
1106
rate
sensiti4it"
flo+
AAAAAAAAAAAAAAAAAAAAA
net profit
profit, to change in interest
expense: A change in interest
rates from &; to ,; +ould lead
to %$; rise in the interest
expense
Input price
sensiti4it"
Gross cash
flo+
cost price per unit
AAAAAAAAAAAAAAAAAAAAAAAA
total cost per unit
/he multiple of the change in
total cost per unit, to the change
in the price of a ra+ material
Production
Sensiti4it"
'production
le4erage)
Net Profit units x 'unit sale price F unit 4aria0le cost)
AAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAA
units x 'sale price F unit 4aria0le cost) F fixed
costs
/he multiple of percentage
change in net profit to the
percentage change in production
4olumes:
/ime
Sensiti4it"
Net Profit
expenses
AAAAAAAAAAAAAAAAAAAA
income A expenses
/he multiple of the percentage
change in net profit, compared to
a percentage change in time
periods, +here income is fixed
and expenses are timeA
dependant:
6iscellaneous
Averages
items of number
items individual the of sum
average
items of number average total

i
i i
(
( x
average (eighted
/a-ital Asset 5ricing Moel
( )
f f m s
r r r r
Deighte Average /ost o+ /a-ital
e!uity debt
e!uity of t cos e!uity debt of t cos debt
capital of t cos average (eighted
+
+

1110
4egative /ash 2lo!
outflo( monthly net
capital available
remaining months
1111