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Business Economics – notes
 Economics - a social science that studies how individuals, governments, businesses and
nations make choices on allocating scarce resources to satisfy their wants
...

 Two of the major approaches in economics are named the classical and Keynesian
approaches
...

On the other hand, Keynesian economists believe that markets react very slowly to changes
in equilibrium (especial to changes in prices) and that active government intervention is
sometimes the best method to get the economy back into equilibrium
...
The word economy can be
traced back to the Greek word oikonomos, "one who manages a household," derived from
oikos, "house," and nemein, "to manage
...
" The first
recorded sense of our word economy, found in a work possibly composed in 1440, is "the
management of economic affairs," in this case, of a monastery
...
" What is
probably our most frequently used current sense, "the economic system of a country or an
area," seems not to have developed until the 19th or 20th century
...
Business
 An organization or enterprising entity engaged in commercial, industrial or professional
activities
...

 Any commercial, industrial or professional activity undertaken by an individual or a group
...

 Legal entity, in the view of the law – legal person that is owned by its shareholders
 Business can make contracts, carry on a business, borrow or lend money, pay taxes
Business Economics
 The study of the financial issues and challenges faced by corporations
...
Studies might include how and why corporations expand, the
interactions between corporations and the role of governments in regulation
 Business economics studies how and why corporations make their decisions and how other
economic factors can influence their choices
...
Needs range from basic survival
needs satisfied by necessities, to cultural, intellectual, and social needs (varying from place
and age) satisfied by necessaries
...

Goods
 A commodity, or a physical, tangible item that satisfies some human want or need
...

Services
 Intangible products such as accounting, banking, cleaning, consultancy, education, insurance,
expertise, medical treatment, or transportation
...

Economic system
 An organized way in which a state or nation allocates its resources and goods and services in
the national community
...

 What to produce?
 How to produce?
 For whom to produce?
Types of economic systems
 Market economy – decisions regarding production and distribution are based on supply and
demand, prices of goods and services are determined in a free price system
 Planned economy – decisions regarding production and distribution are based on central
planning formulated by a central authority

 Capitalism – production is carried out to maximize private profit, decisions are determined by
competing business owners in the marketplace
 The means of production are owned primarily by private enterprises
 Socialism – production is carried out to directly satisfy economic demand by producing goods
and services for use
 The means of production are publicly owned, or owned by the workers cooperatively
 Reality is mixed economic systém
...

Factors of Production
 Land, labor, capital
 All of the inputs needed to produce a good or service

 Labor is all of the work that laborers and workers perform at all levels of an organization
...

Businesses
 Legal entity that has common characteristics:
 main purpose is to achieve profit
 to satisfy needs of customers
 needs of customers are safisfied by products and services on the market – there is
lots of risks
Characteristics of the firms
 Owners
 Managers
 Objectives
 Resources
 Administrative or organizational structures
 Performance assessment by owners, managers and other stakeholders
 Shareholders/stockholders x stakeholders

 Shareholders vs
...
The governance structure specifies the distribution of rights and responsibilities
among different participants in the corporation (such as the board of directors, managers,
shareholders, creditors, auditors, regulators, and other stakeholders) and specifies the rules
and procedures for making decisions in corporate affairs
Insider systems
 typical for Europe and Japan
 concentrated ownership
 dominance of institutional shareholders

 shares infrequently traded, in large blocks
 no takeover activities, or mergers done by agreement

Outsider systems
 typical for UK and USA
 dispersed share ownership
 dominant owners being nonbank financial institutions and private individuals
 shareholders seen as passive investors
 shares easily sold, held for investment purposes rather than for control purposes
 dissatisfaction with the performance leads the shareholder to sell shares than initiate
changes in management
Business objectives
1
...
Sales revenue maximization
3
...
Shareholder value maximization
5
...
Achieving brand recognition
7
...
Social-benefit-maximizing

Different for small and large companies
Owners x managers x stakeholders
Types of goals:
1
...
Conflicting – achievement of one goal prevent from achievement of another goal
3
...


Theories of business objectives
1
...
Sales revenue maximization
1)

Profit maximization

 Traditional objective of the owner-managed firm
 Short-run objective
 Profit = Total revenue (TR) – Total cost (TC)
Criticisms of profit maximization
 Profit maximization could be a poor description of what many firms actually try to achieve
...

 No single objective may be maximized
...

 Sales are measurable, can be used as a specific target to motivate staff (profits are residual)
...

Organizational structure
 internal organization of the company
 can be structured in many different ways, depending on its goals
 determines the hierarchy within an organization
Basic types
1
...
divisional
3
...
sales
b
...
accounting
d
...
human resources
f
...
work on similar product or service
b
...
work in the same geographical location
Advantages:
 allows a team to focus upon a single product or service
 allows to build a common culture
 the divisions will receive resources they need
Disadvantages:
 competing divisions may allow office politics to affect its view – on allocation of company
resources -> one division could act to undermine another
3) Matrix structure
-combines functional and divisional structures
-individuals work across teams and projects and within their own department or function as
well
Advantages:
 resource coordination – allows supervisors to focus on their areas of expertise
 allows for human resources to be shared flexibly across different projects or products
 better communication between different functional areas
Disadvantages:
 can result in internal complexity
 employees can become confused as to who is their direct supervisor
 is more expensive to maintain – double management
 competition for scarce resources and employees

Business life cycle
 is used to model organizational growth and development over the course of time
 describes evolution of businesses through multiple stages
a) Start-up / Birth
 companies are being created
 the future development is planned
 planning is the most important activity
 companies accumulate capital, hire staff and buy equipment
 start developing products or services
b) Growth
 characterized by rapid sales and size growth
 accompanied with investment in marketing, property, and equipment
 customer base is expanding

-

-

c) Maturity
the sales growth is slowing, pricing may become more competitive
companies are usually stable enough to survive most unfavorable circumstances
to avoid decline stage – take a variety of actions to restart growth

d) decline
inevitable for companies which don‘t try to improve growth
companies are unable do define new markets or products, are dependent upon existing
ones
sales, profits are declining
could proceed to radical changes
may end in liquidation and dissolution

Basic Stock and Flow Variables
 stock variables – do not have any time dimension, just describe the state of nature at a given
instance of time
 flow variables – attached with a certain time period, describe evolution of the state of nature
during this period

Basic Stock Variables
 Asset x Equity x Liability (závazky, pasiva, ručení, odpovědnost)
 Asset – economic resource, any property which can produce value and can be owned, can
have monetary value, can be tangible or intangible
 equity – amount of funds contributed (přispěno, darováno) by the owners
 liability – obligation which binds a company to settle a debt
Fundamental rule in BE
Assets = Equity + Liabilities
Basic Flow Variables
 Revenue x Costs x Cash receipts x Cash expenses x Earnings
 Revenue (sales, turnover) – monetary income which company receives from normal
activities – sales of products and services; is recorded when company provides a
transaction (whether or not it has received the payment)
 Cash receipts – represent real increase in the organization‘s cash
 Costs - represent monetary value of consumed inputs, could be or could not be a real
outflow of money
 Cash expenses – represent the real decrease in the organization‘s cash
 Profit = Revenue – Costs
 Profit = Earnings, Income, Accounting profit
 Cash flow – change in cash =
 Cash receipts – Cash expenses
 Economic profit = Revenue – Costs – Opportunity costs
 Opportunity costs – are equal to the value of the next-highest-valued alternative use of our
resources
 should be taken into consideration when making managerial decisions

Business Risks
 every company faces business risks while doing the business
 means uncertainty/risk in profits or danger of loss because of some unforseen events in
future

Business risks classification
 internal risks – arising from the events taking place within the organization
 external risks – arising from the events taking place outside the organization
Internal risks factors
 human factors
 technological factors
 physical factors
 operational factors
External factors
 economic factors
 natural factors
 political factors
Main types of business risks
 Financial risk – associated with financing
 Strategic risk – associated with the operations of particular industry (business
environment, investors
...

Financial risks
 Market risk – interest rate risk, currency risk, commodity risk
 Liquidity risk – risk that a given asset cannot be traded quickly enough to prevent a loss
 Credit risk/default risk – associated with a borrower going into default and is not able to
make payments
Decision making
 decision making under certainty – we know which state of nature will occur
 decision making under risk – we know the possible states of nature and their probabilities

 decision making under uncertainty – we know the possible states of nature, but we don‘t
know probabilities
Expected value (EV)
 to take account of risk or uncertainty business planners will asign to each pay-off a
probability or likelihood of occurence -> to calculate the expected value
 N = number of possible states of nature
 xi = the value of the random variable when the state of nature i occurs
 pi = probability of this state (the sum is 1)
Measurement of risk
 variance
 standard deviation
 coefficient of variation
Variance
 variance is the expected value of square difference between the value of X and expected
value
 the greater variance, the greater overall risk
Standard deviation
 square root of variance
Coefficient of variation
 ratio of standard deviation and expected value
Comparing multiple options
 meaning of the numbers becomes clearer when comparing among multiple options or
possible projects
 if choosing betwen A and B options, we choose A if and only if
 A has a higher expected return and strictly lower risk
 A has lower risk and a strictly greater expected return
Time Value of Money
 basic element of interest rate theory
 central concept in business finance and in economics

 -> amount of money received in the future is worth less than the same amount received
today (now we can invest and earn a return on it)
 Present value (PV) – amount of money which we have today
 Future value (FV) – amount of money which we will have in the future
 Debt – temporary obligation of a debtor (borrower) to pay a certain amount to a creditor
(lender)
 Principal – sum of money owed as a debt
 Interest – cost of borrowing money for the debtor, and reward for the creditor
 Interest rate – percentage of the principal charged for its use, usually noted on an annual
basis - p
...

 Amortization – paying off a debt, each payment is usually decomposed into interest and
principal (balance reduction) portions (cost x cash expense)
 Annuity – constant payment
 Perpetuity – constant payment with no end (infinite stream of payments)
Compounding and discounting
 Compounding – aim si to calculate FV
 Discounting – aim is to calculate PV
Compound interest
 if interest is compounded yearly – after one year the interest is added to the initial
principal and becomes new principal for the second year
 creditor earns interest on interest
Nominal, Effective and Real Interest Rate
 Nominal interest rate – in loan agreements, lists of charges of banks, usually noted on
annual basis (in)
 Effective interest rate – banks add interest more frequently to the account (monthly,
quarterly
...

 take the reciprocal (inverse), the reciprocal is called sinking fund factor
Capital Recovery Factor
 situation where we are paying off a debt using constant payments (annuities)
 inverse value of the present value of an annuity factor is called capital recovery factor
Perpetuity
 infinite constant stream of payments – perpetual annuity
 aim is to calculate PV of this infinite series of payments
Amortization Schedule
 when creating business plan every entrepreneur must know the founding budget -> part of
financing plan is usually a debt
 amortization schedule is a scheme which summarizes the information regarding the
amortization of a loan
 we can see each payment and its structure – interest and principal/balance reduction
portions
Types of businesses
Business entity
 commercial, corporate or other institution that is formed and administered as per
commercial law
 is engaged in business activities
 many types of business entities are defined in the legal system of different countries
Types: Depending on:
1
...
economic sectors
3
...

Partnership
 General Partnership – an agreement between two or more individuals or entities to jointly
own and operate a business; profit, loss, and duties are shared, each partner si personally
liable for the debts
 Limited Partnership (LP) – general partner organizes and manages operations, and limited
partners contribute capital but have limited liability, play no active role in business affairs
 Limited Liability Partnership (LLP) – one partner is not responsible or liable for another
partners misconduct (usually doctors, lawyers
...

The European Union
 common are special business entities, are covered under business formats like
partnerships and companies
EEIG
 European Economic Interest Grouping – convenient for companies to do businesses
together, or to take part in different programs offered by the EU
 special legal entity to facilitate cross-border operations among companies
 has unlimited liability, does not pay corporation tax
European Cooperative Society
 could be established within the area of the EU, allows to shift head office and registered
office from one state to other without the need of registering
European Private Company
 legal form of private limited company projected by the European Commission
 objective of this proposal is to eliminate the significant burden of small scale businesses
Economic sectors
 any economy can be divided into sectors
 an area of the economy in which businesses share the same or a related product or service
Traditional classification
 A – agriculture
 I – industry

 S – services
Agriculture
 production, distribution and consumption of agricultural goods and services
 agriculture, fishing, forestry
Industry
 this sector takes the output – raw materials – of the agriculture and manufactures finished
goods
 could be divided into
 light industry – less capital intensive, more consumer-oriented, produce for end
users (clothes, shoes, furniture, electronics
...

Sectors by ownership
 Business sector
 Private sector
 Public sector
 Voluntary sector
Business sector
 part of the economy made up by companies
 domestic economy, excluding the economic activities of government, private households,
and nonprofit organizations
Private sector
 citizen sector run by private individuals or groups, usually as a means of enterprise for
profit
 is not controlled by the state

Public sector
 provides basic government services – police, military, public roads, public transit, primary
education, and healthcare, street lighting
 non-payers usually cannot be excluded from
Voluntary sector
 also non-profit sector
 social activity undertaken by organizations that are not for profit
The size of the business
 definition varies by country and by industry
 most common used criteria:
 number of employees
 annual sales
 value of assets
 net profit
 more than 90 % in developed countries are small and medium businesses (called SME)
in the Czech Republic – 99 %, EU 99 %
 Investments = postponed consumption
 When investing we forego(vzdát se) today‘s consumption in order to produce a higher
value in the future
When evaluating investment projects the criteria are:
 profitability
 risk
 liquidity
Main criteria mutually interrelated (ve vzájemném vztahu)
 Profitability and risk positively correlated (ve vzájemném vztahu)
 Greater liquidity – lower profitability and lower risk
 Investment is associated with its cost (initial outlays – IN) and expected revenue (receipts)
 Costs should include not only the purchase cost, but also the outlays associated with the
liquidation or sale of assets

 Expected revenue – quantified by cash flow instead of earnings – time value of money
Methods for assessing (zhodnocení) investment performance
1
...
Payback period
3
...
Internal rate of return
Return on investment (ROI)
 Profitability ratio often used in marketing and financial management
 Does not take into consideration the time value of money
 Profitable projects have ROI>1
 Objective is to maximize ROI

Payback Period
 intuitive method which tells us the period of time until the investment is repaid
 after PP years the investment will be repaid
 aim si to minimize the payback period
Discounted Payback Period
 CFt is worth only CFt/(1+i)t
Net Present Value
 difference between the present value of future cash flow streams and investment outlays
 most widely used method
 takes into consideration the factors of time and risk

Internal Rate of Return (IRR)
 method based on NPV
 rate of return that makes the NPV of a project equal to zero
 aim is to maximize IRR, should be greater than minimal acceptable rate of return

Costs and Breakeven Point Analysis
Cost management
 one of the most important aspects of business management
 costs – monetary value of consumed inputs in a company‘s effort to generate revenue
 classified in two ways:
 classification by nature – materials, services, personnel expenses, depreciation and
amortization, financial costs
 classification by function – manufacturing, selling, general administrative, financing
Costs by nature
 Materials – basic raw materials – components, fuel, packing material
...

 Personnel expenses – wages, salaries, social insurance, pension charges
 Depreciation and amortization – loss in value of long-term assets
Depreciation and amortization
 most frequently used technique – straight-line depreciation
 annual depreciation = cost of asset/useful life
 if we know depreciation rate:
 annual depreciation = cost of asset x depreciation rate
Cost Function
 total costs – full costs of producing a given level of output
 can be modeled using the cost function – function of several variables
 two portions:
 fixed costs (FC) – does not change with output volume, exists in short term
 variable costs – changes with output volume

 TC = f(Q) = FC + b x Q
b
...
; business selling goods or
services
...
Sales and Marketing
2
...
Production
4
...
Investments
6
...
Management
8
...
, Xn)
X1
...
the balance sheet
2
...
the cash flow statement
Balance Sheet
 summary of assets and capital of the company in a certain instance of time

 two sides – left-hand side (assets, what the company owns), and right-hand side (equity
and liabilities, what the company owes)
 assets must always equal the sum of equity and debt
Assets (A)
 long-term x short-term
 long-term assets – supposed to be used for more than 12 months
 tangible assets – buildings, land, machines, vehicles, equipment, furniture
 intangible assets – software, patents, copyrights
 the value of long-term assets is reduced by depreciation or amortization
 short-term assets – supposed to be used by the company within less than 12 month
 savings, cash, receivables, inventory, intermediate products, products in stock
 are more liquid than long-term assets
Equity (E)
 amount of funds contributed by the owners of the company
 main components – contributed capital and retained earnings
Liabilities/debt (D)
 amount of funds contributed by the creditors of the company
 long-term liabilities – payable in a time frame longer than one year
short-term liabilities – payable earlier than in one year (short-term loans, accounts payable, unpaid
salaries, unpaid taxes
Accounting Equation
 A=E+L
Possible changes
 there are only four possible changes in the balance sheet
 an item on the left-hand side increases and an item on the right-hand side
increases by the same amount (+,+)
 decrease by the same amount (-,-)
 an item on the left-hand side increase and another item on the left-hand side
decrease (+/-,0)

 (0,+/-)
Income Statement
 summary of revenue, costs and profit for a certain period of time

 profit = revenue - costs

Operating income
 income derived from sources related to a company‘s everyday business operations
 x operating expenses
EBIT
 earnings before interest and taxes = operating revenue – operating expenses

EBT
 earnings before taxes = EBIT – interest expense
EAT, net income
 earnings after taxes = EBT - taxes
Cash Flow Statement
 summarizes the real flows of cash within the company
 shows certain flow variables for a period of time – one year
Methods
 how to calculate cash flow
 direct method – by substrating the money receipts and expenses we get net change
in cash
 indirect method – principle is to use as a starting point the output of the income
statement – the earnigs
Indirect method
CF = EAT
+ costs which are not cash expenses

- cash expenses which are not costs
+ cash receipts which are not revenue
- revenues which are not cash receipts
Financial Analysis
 represents a basis for any rational financial decision
 allows to determine the financial health of a company, to identify its weaknesses and
threats, to analyze financial problems and to propose solutions
General steps
 gathering data
 processing data
 horizontal and vertical analysis
 analysis of financial ratios
 analysis of the time development of financial ratios
 analyzing the relationships among ratios
 comparison with industry averages
Sources
company‘s financial statements, external sources such as official statistics, other companies‘
annual reports and financial statements
Horizontal and Vertical Analysis
 horizontal analysis – process in which each entry is compared over a certain period of time
in terms of absolute and relative change (amount of assets in 2
...
year)
 vertical analysis – process in which each entry for each of the major categories of account
is represented as a proportion of the total sum in certain year (current assets/total assets)
Financial Ratio Analysis
 company can be assessed according to many criteria
a) profitability
b) liquidity
c) activity

d) financial leverage (debt)
e) market performance
-> ratios of two absolute values
a) profitability ratios
 profitability = ratio of earnings over invested resources; measures the ability to generate
profits with given resources
 company can be considered profitable if its profitability exceeds the alternative return
 ROE, ROA, ROS
ROE - return for shareholders
 return on equity – defined as net income (EAT) over E
 ROE = EAT/E
 measures the ability to generate profits from every unit of shareholders‘ equity
 return for shareholders
ROA - return on the whole capital
 return on assets – ratio of income over total assets
 ROA = EBIT/A
 represents profitability of total assets and the return for shareholders and creditors, since
A = E+D
ROS
 return on sales or profit margin
 ROS = EBIT/S
 return on sales measures the abilitiy to produce either at low cost or at high price
Liquidity ratios
 liquidity of a company is the ability to meet its loan obligations (current liabilities) – is
called solvency
 liquidity should neither be too low nor too high
 current ratio, quick ratio, cash ratio
Current ratio
 current ratio = current assets/current liabilities

 should be between 1
...
0 for healthy businesses
 supposes that all current assets are liquid
Quick ratio
 calculated by subtracting inventories from current assets
 quick ratio = (current assets-inventories)/current liabilities
 more accurate measure
 standard values – 1
...
5
Cash ratio
 cash ratio = cash/current liabilities
 0
...
0
c) Activity
 ratios of activity or asset management ratios
 how efficient the firm is in asset management
 asset turnover, fixed asset turnover, inventory turnover, receivables turnover
 asset turnover = sales/total assets
 fixed asset turnover = sales/fixed assets
 inventory turnover = sales/inventory
 receivables turnover = sales/receivables
-> should be compared against industry averages to obtain some relative measure
Leverage ratios
 financial leverage ratios measure the debt usage
 debt ratio, D/E ratio, equity multiplier
Ratios
 debt ratio = debt/total assets
 D/E ratio = debt/equity
 equity multiplier = total assets/equity
-> it equals 1+D/E

) Market performance
 the market could be source of data as well
 market/book ratio = market price per share/book value per share
 for companies which are freely traded
 book value per share can be calculated as total equity over number of shares
 should be greater than 1
 P/E ratio = market price per share/earnings per share
...
cost of debt
Cost of Equity
 the most expensive part of capital is equity
 cost of equity (ke) is required rate of return for shareholders (or they invest capital into
another company) – opportunity costs of the shareholders
Cost of Debt
 cost of debt (kd) – less than the cost of equity – interest rate which reflects the risk of debt
provision
 long-term debt is more expensive than short-term debt – the longer the PP of a loan is, the
riskier it becomes
Why to use debt
 insufficient proper funds
 more equity sometimes implies more owners, which is not always convenient
 debt is usually cheaper than equity
Disadvantages of debt
 higher level of debt implies higher risk and less financial stability, which result in higher
cost of equity

 in case of higher interest rate the debt becomes more expensive
Matching Principle
 long-term assets should be financed with long-term capital (equity and long-term
liabilities)
 short-term assets should be financed with short-term liabilities
 overcapitalization – company has too much equity – when the ratio of equity over longterm assets is greater than one (equity also covers short-term assets) -> equity is the most
expensive type of capital – company has problems with profitability
 undercapitalization – the ratio of long-term assets to long-term capital (equity plus longterm debt) is greater than one -> short-term liabilities cover long-term assets -> problems
with liquidity and solvency

Net Working Capital
 indicator of business financial policy – net working capital (NWC)
 NWC = current assets – short-term liabilities
 NWC – a part of long-term debt which covers the short-term (current) assets
 its kind of reserve capital for „bad times“
 its not for free – long-term debt is more expensive than short-term debt
Interest Tax Shield
 one of the reasons why debt is less expensive than equity is interest tax shield
 interests are costs which reduce the tax base
 tax shield – amount of taxes that a firm is allowed not to pay because of its lower tax base
 kd = i x (1 - t) -> actual cost of debt
 company spares i x D x t dollars -> tax shield

Financial Leverage
 it‘s one of the advantages of debt over equity
 we know ROE (return for shareholders) and ROA (return on the whole capital)
 debt acts as a lever which pushes up the company‘s ROE -> increasing the debt portion of
capital raises ROE

 ROE = ROA + (ROA – i) x D/E
where: D/E – financial gearing – ratio of debt over equity, measure of overall debt level
 idea of this equation is that ROE exceeds ROA, there are three possibilities:
 ROA > i, that means (ROA – i) is positive and increasing D/E results in higher ROE ->
financial leverage is positive
 ROA = i, (ROA – i) = 0, increasing D/E has no effect, financial leverage is neutral
 ROA < i, (ROA – i) is negative, financial leverage is negative
Rule
 if financial leverage is positive, additional debt is recommended – magnifies ROE
Optimal Capital Structure
 WACC – weighted average cost of capita

we want to have the lowest cost of capital possible – minimum WACC
Business Plan
 formal statement of business goals, reasons they are attainable, and plan for reaching
them
 contain background information about the organization
 when planning a new business, or trying to introduce a major change, a 3 to 5 year
business plan is required -> investors look for annual return
 may be internally or externally focused
 externally focused plans target goals important to external stakeholders – investors and
customers, tax-payers

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