In the previous lesson, we introduced how a business runs and detailed an illustration of how a business runs. In this lesson, we will look into how money flows through a business using Samuel’s business model.
Flow of money through a business to the owner/Income
As a recap, Samuel owns a Sausage business in the city. He has employed an employee who sends him a cheque at the end of every year. We have assumed Samuel’s business is fairly stable.
Now to illustrate the flow of money:
- Assume customers buys sausages worth 1000 shillings from the business. Now The 1000 shillings is indicated as sales in some financial statements and other words with identical meaning can be used depending on the company but they all mean the same thing.
- The business also incurs costs. We can assume that, Samuel pays employees 200 shillings and buys sausages worth 400 shillings and pays local authorities locally known as ‘Kanjos’ 100 shillings. That means that, Samuel’s business spends 700 shillings to make the 1000 shillings from the sausages that it sells.
At this point, the business makes a profit before deducting taxes of (1000-700) shillings which is 300 shillings. Assuming that the business pays taxes to the government worth 100 shillings, Samuel is entitled to receiving 200 shillings from the business at the end of the year. I have assumed that he hasn’t taken a loan. If he had taken a loan, the interest he pays on the loan would have been deducted before the taxes are calculated.
The 200 shillings that Samuel receives is called net EARNINGS or net income. It is important to remember this term since you will often hear it mentioned in reports provided by the company or by analysts. Earnings are important since they represent what the owner should get. That is the money that went through the process and comes to you.
Since we now know that Samuel is getting money amounting to 200 shillings at the end of every year from his business, as an owner he now has to make a choice on what to do with the money.
Samuel can choose to:
- Take all money and go spend it on say school fees, rent, entertainment or charity whatever he likes
- Grow the business by reinvest all the money to grow business more by maybe buying another stand or even buying out other competitors who might pose a threat to his business. Its all up to him. Of course he can seek advice from his employee who will probably propose a range of ideas.
- Split the money into two, take one portion of it and reinvest the other portion
In both situations where Samuel chooses to reinvest his earnings back into the business, the business will be worth more at that point and may increase his how much he makes at the end of every year depending on whether his investment works.
Comparing Samuel’s business to a bigger listed company.
As is illustrated above, Kenya Power, the national electricity distributor on the left operates in a model very similar to Samuel’s business in the right. The owners are represented by the board of director. The CEO and other employees involved in the day to day running of the business are just employees of the company.
That basically roughly highlights how a business runs. Next we shall look into how to value a business in terms of earnings which is one of the most commonly used approaches by market participants.