Accounting, costs and financial capital

Accounting records every money transaction a business makes and turns those records into reports. Financial management uses the reports to plan: how much money the business needs, where the money should come from and how to spend it. Owners and managers read the reports from inside the business; lenders, investors and tax authorities read them from outside.

A budget is a plan of expected revenue and spending for a coming period. At the end of the period, managers compare actual figures with the budget. The gap is a variance. It is favorable when revenue beats the plan or a cost comes in under it, and unfavorable when revenue falls short or a cost runs over.

Fixed costs, such as rent, insurance and equipment leases, stay the same in total when output changes over a normal range. Variable costs, such as materials, packaging and fees charged on each sale, rise and fall with output. Total cost = fixed costs + (variable cost per unit x number of units).

Spending on something that lasts for years, such as an oven or a van, is a capital expenditure. The business does not count the whole price as an expense in the year it buys the item. It spreads the cost over the item's useful life, and that yearly share is depreciation. With straight-line depreciation, yearly depreciation = (cost - salvage value) / years of use. The asset's book value is its cost minus all the depreciation recorded so far.

Financial capital is the money a business uses to start, run and grow. Debt financing means borrowing, through a bank loan, a line of credit or bonds: the business repays the money with interest, and the owners keep full ownership. Equity financing means selling part of the ownership to investors, such as friends and family, angel investors or venture capital firms: nothing is repaid on a schedule, but the owners give up a share of control and of future profits. A business can also use retained earnings, profits it kept instead of paying them out.

The break-even point is the output at which total revenue equals total cost, so the business makes neither a profit nor a loss. Each unit sold brings in its price, but part of that pays the unit's own variable cost. What is left, price minus variable cost per unit, is the unit's contribution margin: the amount it adds toward fixed costs.

Break-even units = fixed costs / (price - variable cost per unit). Below that output the business has a loss. Above it, each extra unit adds its contribution margin to profit, so profit = (price - variable cost per unit) x units - fixed costs.

When you explain a financing choice, compare the options side by side: say what the business gains with each one and what it gives up, and tie both to the business in the question.